09 February 2010

Published in: Regulation - supervision

CEIOPS’ final advice sets tone for QIS5

There are disappointments for the industry on some issues, and decisions on other points have been deferred in the final advice on the Solvency II level 2 implementing measures. Here's a shortened version of Towers Watson's guide to the advice.

CEIOPS has delivered its final advice to the European Commission on the vast majority of areas covered by the third wave of consultation papers for Solvency II level 2 implementing measures. Consultation on this third wave of papers ran from 2 November to 11 December 2009.

The final advice on the calibration of the SCR standard formula for health underwriting risk, non-life underwriting risk and the calibration of the MCR has been delayed to enable CEIOPS to collect further data from member states in order to do further analysis for these calibrations.

CEIOPS plans to produce the revised advice on these topics in time for the draft fifth quantitative impact study (QIS5) technical specifications, which should be released at the end of March 2010.

It is understood that CEIOPS will prepare the draft QIS5 technical specification in line with the final advice except in those areas specified by the European Commission -- for example, in respect of the determination of which future premiums may be included in the technical provision calculation -- and that the conclusions of the illiquidity premium task force will also be incorporated.

CEIOPS has requested a small extension to the original 31 January deadline for the initial report to allow the task force to continue to make progress on key issues relating to the discount rate (see IERM, investment risk, 1 February 2010, "EU watchdog's annuity report due mid-February").

Overall, the most significant changes made were in relation to the calibration of the market stresses for the SCR standard formula and the correlation assumptions. In a number of cases the final advice is unchanged from the consultation papers, but there is further justification of CEIOPS' reasoning. The impact of the final advice on the level 2 implementing measures will be tested during QIS5 later on this year.

Summary of main changes to final advice

Correlations

CEIOPS has conducted further statistical analysis to derive the correlations between risks and, in particular, has introduced two-sided correlations for interest-rate risk depending on whether yields-up or yields-down is the most onerous.

If the yields-up stress is biting, the correlations between interest-rate risk and each of equity, property and spread risk are now zero. The correlation between property and spread risk has been reduced from 0.75 to 0.50, as have the correlations between concentration risk and the other risks (from 0.75 to 0.5), although many will regard this latter correlation as still too high.

There have been some reductions in the correlations in the life-underwriting risk module from 0.25 to zero. Correlations for health risk have also been specified but the structure of the health module may be subject to further changes. The final advice no longer suggests increases to the basic SCR correlations specified in the level 1 text.

Overall, the changes put forward will lead to an increase in diversification benefits but total capital requirements are still expected to be significantly higher than QIS4 (CEIOPS estimates 21% higher for life insurers (previously 24%) and 9% for non-life insurers (previously 13%) on average).

Equity risk

The main changes compared to the draft advice in consultation paper 69 (CP69) are that the stress for "other" equities has been reduced to 55% (from 60%) and the volatility shock has reduced from 60% to 50% (although, unlike the new interest-rate volatility shock, it is still a multiplicative stress and so may generate instability/pro-cyclicality in extreme market conditions). Also the equity volatility shock is now assumed to be only 75% correlated with the equity price shock.

Market risk

The interest-rate stresses have been reduced from those shown in CP70 (and are now weaker than those applied in QIS4 with the exception of the interest-rate down stresses for shorter durations) and the volatility shock is now specified as an absolute (rather than percentage) stress of either 12% up or 3% down. The interest-rate stress and the volatility stress are now assumed to be uncorrelated.

The property stress has been simplified and is set at 25% for all property types (where previously city offices, warehouses and retail had a 30% stress test attached to them).

The credit-spread shocks for corporate bonds have been reduced and are now much more in line with current individual capital assessment (ICA) stresses used in the UK and many companies' economic capital models, although they are still significantly higher than those stresses applied in QIS4.

There is now also a separate calculation for mortgage loans. The reduced interest-rate and credit- spread stresses and the introduction of the separate mortgage loan stress are very positive outcomes for the European insurance industry.

Treatment of participations

The advice given by CEIOPS in this area remains largely unchanged which may come as a disappointment to the insurance industry.

Repackaged loan investments

The principles set out for investment in repackaged loan investments have changed very little and the proposals continue to impose potentially onerous compliance costs on both issuers and investors in securitized loans. Several stakeholders commented on the practical difficulties that insurers would face in carrying out the required due diligence and monitoring the requirement for originator/sponsor to retain a 5% economic interest.

However, CEIOPS has maintained its position and responded that insurers who found the requirements too onerous may choose not to invest in repackaged loans.

Extension of the recovery period

CEIOPS' initial advice recommended a maximum extension period of 30 months in total. Despite the fact that a number of respondents considered that the maximum timeframe should be longer, CEIOPS could see no sufficient justification to change their original recommendation.

Treatment of ring-fenced funds (RFFs)

CP68 set out in some detail alternative definitions of RFFs. Following feedback, the final advice has been pared back to set out only the high-level principles of RFFs. CEIOPS proposes that more details will be provided in level 3 guidance but notes that it will have to respect national legal, insolvency and contract law and product regulation. This indicates that individual supervisory authorities may very well have a strong role in determining what is a RFF or not.

Undertaking-specific parameters

A number of alterations have been made to the final advice in this area but the main changes of interest relate to the weight given to own company data. Following stakeholder criticism, CEIOPS has increased the credibility weights for internal data so that greater weight can now be placed on an undertaking's own data.

Simplifications for technical provisions

CEIOPS does not propose an exhaustive list of simplified methods and techniques for the best estimate, as a principles-based approach is preferred for the level 2 advice with level 3 guidance to follow. For the risk margin simplifications, however, CEIOPS believes that level 2 guidance is necessary because of the complexity and uncertainty of the calculations. The hierarchy of simplifications has been maintained for the final advice, although CEIOPS supports alternative simplifications where undertakings can demonstrate these are appropriate.

Simplifications for the SCR

The main changes made to the advice in this area were modifications to the specific simplifications suggested in the draft advice. For example, for credit risk, the suggested simplification in CP77 remains but the criteria for average credit rating for long duration bonds being not less than one rating below the credit rating for short duration bonds has been excluded.

Maturity-bucketing has also been replaced with duration-bucketing in line with the change to the market-risk module. For health-revision risk, it was foreseen in CP77 that there would be an adaptation of the life calibrations to reflect the inclusion of inflation and an enlargement of the scope to all kinds of benefits. This has now been dropped and the simplification is identical to the corresponding life module.

For non-life catastrophe risk, CEIOPS has still not given advice on the standardized scenarios and this will be addressed at a later stage. All simplifications that used the technical provisions as an input now use the best estimate instead. The advice still does not include any interest-rate risk simplifications and therefore all companies, including the smaller ones, will be required to discount liabilities using the full yield curve. Some clarification has now been given that quantification of the degree of model error is not required in precise quantitative terms which should help to reduce the burden on firms.

Simplifications for captives

The requirement that the captive's obligations should only relate to contracts where all insured persons and beneficiaries ("option 2") are legal entities of the group of the captive at the time the contract was entered into has been retained. Some additional clarification of the terms "insured person" and "beneficiary" has been provided.

Supervision of group solvency for groups with centralized risk management (CRM)

Mainly points of clarification: for example, CEIOPS has clarified that CRM only applies to groups with the ultimate parent undertaking located in the EEA, and to EEA subsidiaries of those EEA groups.

Partial internal models (PIM)

Again mainly points of clarification. The industry will be somewhat disappointed that, despite strong support for option 3 for PIM integration with the standard formula (where the insurer's chosen method is considered first), CEIOPS has continued to recommend option 2 (where a list of integration methods specified in level 3 guidance is considered first).

It will be important to provide feedback when CEIOPS consults on the level 3 list of integration approaches to ensure that most methods that insurers would select are included within the final level 3 guidance.

Next steps

CEIOPS' final advice on the health, non-life and MCR calibrations is expected at the end of March 2010, along with the draft technical specifications for QIS5. CEIOPS will also begin drafting and consulting on the relevant level 3 guidance.

The European Commission will continue to draw up draft level 2 implementing measures based largely on CEIOPS' advice and discuss these drafts with the solvency expert group.

 

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