13 November 2009

Published in: Capital - models, Operational risk, Regulation - supervision

Pluses and minuses: the final advice weighed up

KPMG's Elliot Varnell analyses the key issues in the CEIOPS documents

Liquidity premiums

The final advice to the European Commission continues to state that most members of the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) do not believe a liquidity premium adjustment is appropriate, and it is clear there is a fear about its being used inappropriately. However, they have put forward a suggested approach for dealing with this issue. This gives the industry more chance to engage in this issue and make its case.

CEIOPS has acknowledged that the liquidity premium issue is important for certain business lines, but they are keen to apply limitations in its application. The final advice contains guidance on when an adjustment for illiquidity in insurance contracts may be permitted along with the other matters that need to be considered. The UK annuity products fit well within the scope of application proposed.

However, there are a number of limitations, which include restricting its use to insurance contracts in existence when Solvency II comes into force. Further changes to the solvency capital requirement (SCR) are also suggested, which include increasing the interest-rate shock and removing the SCR diversification benefit for the business that has the liquidity premium applied. Finally, the quality of the own funds created by using the liquidity premium adjustment would need to be assessed to determine into which tier of capital to allocate the benefit. If this results in the liquidity premium not being treated as tier 1 capital, then the benefit created may be of limited use to insurers.

CEIOPS has said that it is prepared to lead further work on quantification to ensure objectivity and reliability for the liquidity premium measure. CEIOPS' thinking appears to be leaning towards using a percentage of the spread between the highest quality corporate bonds and the government bonds, combined with a cap.

Own funds

There was criticism from the industry of the proposal in consultation paper 46 that tier 1 capital had to have a duration at least equal to the longest liability. This effectively meant that for some companies they could only issue equity as tier 1 capital in practice and not hybrid capital. The industry argued that this would increase the cost of capital for insurers with long-term liabilities.

This requirement has changed in the final advice. Tier 1 instruments must still have a duration of at least 10 years, but the link with the duration of the insurance liabilities has been removed, both here and in respect of tier 2 capital. In addition, CEIOPS recognizes that high-quality hybrid capital should be able to be treated as tier 1, but only provided that in stressed situations, companies convert or write down to provide higher quality capital in the form of equity. A limit of 20% of tier 1 capital has been set. The use of hybrid capital provides more flexibility for the industry and ultimately cheaper capital than if insurers had needed to be 100% equity-funded.

However, there has been no movement on the application of the limits applying to tiers of capital to cover the capital requirements. The industry had expressed concern that CEIOPS had increased the percentage tier 1 capital that is required to cover both the SCR and the minimum capital requirement (MCR), whilst reducing the amount of tier 3 capital that can be used to cover the SCR, when compared to the directive.

CEIOPS argues that there is an inherent trade-off between the requirements for the quality of own funds eligible to cover capital requirements and the limit structure applicable to the tiers to which those own funds are allocated. Despite some improvements, the industry would certainly have been hoping for a lower percentage of required tier 1 capital.

One particular concern expressed by the industry was for the need for some form of grandfathering of existing capital instruments. The final advice states that this will be included in level 2 implementing measures, but the reference to the fifth quantitative impact study suggests that any grandfathering arrangements will be not be known for at least another 12 months. This will be a disappointment to the industry because, if grandfathering is not permitted, it will leave only a limited window in which to restructure their balance sheets.

Risk margin and calculation of technical provisions as a whole

The industry had been concerned at the lack of diversification between business lines allowed in calculating the risk margin. Furthermore, there was concern that the cost of capital rate of at least 6% was too high. The reintroduction of non-hedgeable market risk to the risk margin and the restrictions on calculating the technical provision in consultation paper 41 as a whole were felt to over-complicate the technical provision calculations. Unfortunately for the industry, little has changed with respect to all of these concerns and the original advice in consultation paper 41 and consultation paper 42 remains unchanged.

Operational risk

The industry had complained about the SCR operational risk module calibration which it felt was arbitrarily doubled without any justification. CEIOPS has now lowered the charges by around a third compared to consultation paper 53 which will be welcomed by the industry. Operational risk is the only noticeable place in the final advice where the capital requirements calculations have been reduced since the July proposals.

However, CEIOPS has not reintroduced the ladder factor, which was a mechanism for decreasing the operational risk capital charge for companies that demonstrate improving operational risk management. This will be a disappointment to the industry as it means that there will be little capital incentive to improve operational risk management unless a partial internal model for operational risk is built. This could be challenging.

Disclosure and reporting

There had been concern from the industry on the level of disclosure regarding models and risk management as set out in consultation paper 58. CEIOPS has, in the final advice, relaxed its advice on what needs to be publicly disclosed in the Solvency and Financial Condition Report (SFCR) with much of the sensitive information only included in the Report to Supervisors (RTS). The other concern from the industry was that the time scales on the quarterly reporting were too onerous. The final advice allows insurers some slight extensions for the first two years of Solvency II. However, the final timelines are still likely to represent a challenge for the industry.

The timelines to produce and publish the various documents can be summarized as follows:

Year End	SFCR (solo) weeks	SFCR (group) weeks	RTS (solo) weeks	RTS (group) weeks	Forms (annual) weeks	Forms (quarterly) weeks
1/11/12 - 31/10/13	20	26	20	26	20	6
1/11/13/ - 31/10/14	18	24	18	24	18	5
Thereafter	14	20	14	20	14	4

Source: KPMG LLP based on CEIOPS Advice for Level 2 Implementing Measures on Solvency II: Supervisory Reporting and Public Disclosure Requirements

 

Elliot Varnell FIA is principal advisor at KPMG 

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