The Australian approach
The Australian Prudential Regulatory Authority (APRA) has an ongoing objective to uplift governance, culture, remuneration and accountability (GCRA) in the entities it regulates. Aligned to this, APRA also recognises the importance of strong DEI practices for a resilient financial system.
APRA has previously spoken about DEI in connection with the composition of boards and the importance of having a range of professional and demographic backgrounds to facilitate better decision-making and stronger risk-management. This year APRA will consider how it might strengthen DEI practices across its regulated industries as part of its review of its governance prudential requirements.
Avoiding artificial volatility
Mitigating excessive short-term solvency volatility was one of the key objectives of the Commission’s Solvency II review — an objective shared by the industry. It is therefore disappointing that the Commission has chosen to propose changes that would unnecessarily increase solvency volatility.
Excessive short-term, or artificial, volatility is detrimental because it can increase the incentive to engage in procyclical investment behaviour and it creates disincentives for insurers to offer long-term products and guarantees and to invest long-term. It also typically requires insurers to put in place additional solvency buffers, which are otherwise not necessary, reducing the overall investment capacity of the industry.
The Commission’s proposed alterations to the calculation of the regulatory risk-free interest rates increase the sensitivity of insurers’ balance sheets to changes in the value of long-term swap contracts. This increases solvency volatility, as clearly demonstrated in the impact assessments of the European Insurance and Occupational Pensions Authority (EIOPA), and also creates an incentive to use more derivatives to manage this additional volatility. These negative impacts can be avoided if the calibration of a key parameter — the convergence parameter — is chosen wisely. For the euro, a 20% convergence parameter is considered appropriate and for non-euro currencies, the local market characteristics should be taken into account.
The Commission makes some very good proposals for much needed improvements to the volatility adjustment (VA). However, the Commission has also made a proposal to change an element of the VA called the “risk correction” and this, if included in the review, would undermine the other improvements and add procyclicality into the VA, especially in a crisis period. The current risk correction is already conservatively calculated, has worked well and there is no evidence justifying a change. The risk correction is therefore one element that should not be changed.