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28 June 2010 28 June 2010 Joint CRO Forum and CFO Forum detailed feedback on the draft IMs discussed at the Expert Group meeting on 14 June 2010 This note was written as a joint effort by the CRO Forum and the CFO Forum, describing our view and key issues regarding the draft implementing measures. We would like to thank you for the invitation to comment at this critical point in time in the development of the Solvency II Directive. This letter is a follow up to our previous high level comments sent to you on 11 June 2010 when we provided you with our most immediate concerns ahead of the Expert Group meeting on 14 June 2010. As expressed in our initial feedback sent to EC on 14th June, Main concerning IMs are IM13 - technical provisions (definition and scope of boundaries of contracts, diversification in the risk margin between entities), and IM34 - spread risk (calibration & design of bonds, credit derivatives, structured products, covered bonds, sovereign). For your convenience, we have also prepared a revised mark-up on these draft IMs that present our suggestions and concerns. We look forward to discussing this further with you. IM13 – Technical Provisions Article TP2: Boundaries of insurance and reinsurance contracts We are disappointed that the cover note to the Solvency Expert Group does not adequately represent the industry perspective on an issue that is fundamental to the measurement model underlying Solvency II. In our view the issue at stake is a wider point of principle and not just associated with the interpretation of "unlimited ability". Notwithstanding our discussions on this issue we are of the view that the respective positions are not yet fully understood. Consistently with Alberto Corinti‟s note circulated on 23 rd June, we believe that the proposals for QIS5 and the draft Implementing Measures1 differ from the Industry position in that they exclude all cash flows after the point at which the insurer can change the premiums charged, even if the insurer cannot re-underwrite at individual policyholder level (and so treat the policy as a new contract). This means that it will be excluding the value/ cost of the contract within the technical provisions, as well as excluding the risks associated with this contract within the SCR. This is not in line with the current methodology used by insurers in their Internal Models. Insurers have an ongoing obligation to the policyholders of these contracts and it is not at all considered appropriate to ignore the risks associated with these. We should note that the Industry position would be expected in many cases to result in a more prudent treatment that the current proposals drafted by the Commission. Future premiums likely to be affected and excluded from the technical provisions computations (and related SCR calculations) are group insurance contracts where the contractual premium to be paid by the insured cannot be re-priced at the individual risk profile of the policyholder (e.g. many mortgage insurance policies) and a significant portion of universal life contracts. 1 Both QI5S and IM13 seem to differ from the industry position and also appear to be inconsistent with each other 28 June 2010 As a result, we believe that at least TP2 3. should be deleted as not in line with the principle supported by the industry that premiums that cannot be repriced at the individual risk profile of the policyholder should be included in the future cash flows to be projected out in the technical provisions. TP2. 2. should be deleted as adding confusion. In addition, a recital should be added in order to clarify the intention of TP2. "In determining the boundary of a contract it is important to reflect the obligations of the insurer/reinsurer. An insurer/reinsurer is considered to have a contractual obligation to a policyholder up until the earlier of the point at which the insurer/reinsurer either is no longer required to provide coverage; or has the right to reassess the risk of the individual policyholder and, as a result, can set a price or amend the benefits to fully reflect that risk. The boundary of a contract is the point at which the insurer/reinsurer's obligations cease." Article GTP: Risk margin We would like to reiterate our concern that the risk margin does not recognise group level diversification in the current draft. Only by its inclusion can the risk margin fully reflect the underlying economic principles of market consistent valuation. This is a critical issue. An economic value must reflect what is being transferred. As the CEA report clearly demonstrates, in nearly all cases companies or group of companies rather than individual business lines are transferred into another group structure and not into an empty shell, where group diversification benefit will continue to prevail. In addition, from the conceptual perspective on transfer value, the potential buyer would only be compensated for non-diversifiable risks, ie after recognition of all diversification effects. This demonstrates that diversification within the group should be fully taken into account within the risk margin at group level as the transfer value is the value of the company. In addition, we believe that diversification benefits between life and non-life companies are appropriate and therefore would like TP18 (b) to be deleted. This full group diversification in the risk margin shall be explicit on the fact that the company or single entity would not be sold or transferred to an empty shell, but into another group structure which is well diversified. Article TP18: Residual market risk With regard to calculating the risk margin, we would like to restate our support for the assumption that assets have been selected so the SCR for market risk has been eliminated (rather than simply minimised). The residual market risk may be minimal and difficult to estimate, so assuming its exclusion is desirable. When difficult to assess or expected to be minimal, in such cases, we suggest undertakings would have to document in the context of Pillar II processes the absence of residual market risks being taken into account. Under Article TP 18 paragraphs (g) and (h) the unavoidable market risk is still included in the Risk margin. We recognize that some discussion may still be required on how to practically treat the question of unhedgeable risks in the risk margin in relation to the question of the definition of the discounting curve and its extrapolated part. This can be done within QIS5. However it is imperative that any solution needs to be practical and guarantee no double-counting of risks with the SCR. In particular, the interest rate shocks in IM27 have also not been adjusted to exclude the non-hedgable interest rate part. If this is not addressed then the unavoidable market risk will be accounted for three times, once in the risk margin, once in the extrapolation and once in the interest rate SCR. We have already suggested amendments to IM27. For the consistency with the extrapolation we suggest to add text that the Risk margin for unavoidable market risk should be set in a consistent manner with the risk incorporated in the extrapolation. Tax: TP18.1.(j) “the is no loss-absorbing capacity of deferred taxes as referred to in Article 108 of Directive for the reference undertaking” This should be aligned with the other items in Art 108. The loss-absorbing capacity of deferred taxes should be the same as in the original undertaking. This is more in line with economic reality and would align with (i). The concrete drafting suggestion would be to delete this paragraph 1.(j) Article TP26: Lines of business The definition of lines of business proposes segmentation by Member State. We believe this requirement is excessively granular and will be onerous for undertakings to implement. Further, it is not clear why segmentation in addition to that set out in Annex I is required as this is not a requirement of the Directive. IM20 –Technical Provisions The text (in IR2 (3)) states that government rates shall be used when swap rates no longer available/not liquid as set out in TP21. 28 June 2010 A government bond curve should only be considered if it is reliably available at longer tenors than swaps. Further, there should be a smooth transition from swaps to government bonds if this applies to avoid arbitrage. The illiquidity premium should apply to the forward curve rather than the spot curve. Please see our QIS 5 technical specification on the risk free rate dated 1 April. Article IR6: Illiquidity premium observed in the financial markets We reiterate our response that the calculation of the illiquidity premium observed in the financial markets should be based on a clear methodology that builds on the experiences and data in that market and avoids uncertainty around how the calculation is carried out based on those observations. Consequently, we strongly believe that the formula based on a transformation of the observed credit spread, as developed by the CEIOPS led taskforce (reported 1 March) and presented in our QIS 5 risk free rate technical specification (1 April), should be included in the Level 2 text. We further recommend that the calibration of the illiquidity premium formula as per IR6 is considered as part of the review mechanism outlined in IR9. We note also that the calibration of the formula mitigates undue pro-cyclical effects with the illiquidity premium being significant in periods of stress and otherwise close to zero. It would be prudent to review the calibration after a period of time to ensure this structure is working in different market conditions. Critically, this would also negate the need for anybody (be it EIOPA or anyone else) to be tasked with determining whether a market is or is not in “stress” which causes uncertainty and runs the risk of exacerbating the volatility in the market. Introducing such uncertainty cannot be a sensible basis for the regulatory framework as it requires capital to be assessed on an on-going basis. We do not believe anybody (including EIOPA) should make this subjective judgement. The formula (subject to periodic review) should be allowed to operate automatically to determine the level of illiquidity premium relative to market conditions. The lack of an explicit formula and this text puts a lot of uncertainty to the industry of when illiquidity premium can be applied. So we object this text as it does not recognise that liquidity is in fact a continuum. Article IR7: Portion of the observed illiquidity premium corresponding to insurance or reinsurance obligations We welcome the developments to date over the application of the illiquidity premium to liabilities and recognise the increased scope of liabilities that will attract an illiquidity premium. With reference to our paper to the EC dated 20 May, we believe that a 75% portion of the illiquidity premium should be applied to other products with discretionary benefits, including, US style fixed annuities. As noted in previous responses, we welcome the recognition that in an economic based approach the liabilities would be re-stated in stress conditions and would therefore reflect the changing liquidity premium in the case of the stress of spreads. We are therefore concerned to see that this is not recognised in the most recent relevant draft IM on spread risk. The CFOF would be happy to work with the Commission to ensure that this reflects the recognition of the LQP in the base case and in particular the "predictability buckets” and the interaction with the transitional provisions to ensure a consistent treatment. Article IR8: Transitional Provisions CFO Forum and CRO Forum will come back to the Commission at a later stage on general principles to be applied to transitional provisions. Transitional provisions are welcome and should be re-assessed once all implementation measures are finalized. IM34 - Concentration Spread Risk This is a very concerning IM. We strongly recommend a decrease in the spread risk factors (bonds, credit derivatives, structured products, covered bonds, sovereign). Bonds: As presented in our CRO Forum study on market risk calibrations (March 2010), there are 2 options for calibrating the corporate bond spread stress tests: Option 1 is a recalibration of the same stress test framework proposed by CEIOPS, based on CDS. It involves an alternative calibration to the Credit Default Swap (CDS) market removing some of the biases in the original CEIOPS calibration, based on more representative indices. Option 2 is a more theoretically sound approach but more complicated for implementation. This method involves calibrating to Corporate Bonds but allows for a liquidity spread widening offset on 28 June 2010 the liabilities. The degree of liquidity allowed for in the liabilities depends on the predictability of their cash-flows. It follows the work of the CEIOPS Liquidity Premium Task Force. Since the illiquidity premium has been omitted in the spread module, the spread shocks should be calibrated net of the liquidity premium. Therefore we propose that the draft IM34 uses the CRO Forum proposed calibration for option 1. (See marked up IM attached) We also propose reductions in Maximum duration (to values in CEIOPS‟ final advice), with the Max duration on a single exposure without credit assessment being 6 years. Credit Derivatives: • CDS (not qualifying as hedges) subject to 600% spread widening or 75% spread narrowing. We strongly disagree with this arbitrary approach. In the calibration paper, CEIOPS focused on the CDS sold by institutions that defaulted during the crisis which created inconsistency with the calibration and the treatment of bonds. The issue of the default of the counterparties in CDS transaction is more relevant in the calibration of the counterparty sub-module. • Credit Default Swaps should be treated in the same way as corporate bonds (i.e. based on the rating of the underlying name). For the calibration of CDS in the spread module, we recommend using the same calibration than for bonds – what we call Option1 (ie. CDS data and not real bonds index). The credit quality should be set equal to the rating of the underlying bonds of the credit derivative while the duration should be set equal to the maturity of the credit derivatives. • We propose that maximum durations should equal the values in CEIOPS‟ final advice. (See marked up IM attached) • A different CDS shock would give the wrong risk management incentives: companies will optimize their SCR by including hedges either in the bonds module or in the CDS module (if there is a large part of CDS where protection is sold, it will be cheaper to treat hedges in the CDS module since they will lead to a netting). Structured Assets: • Although in IM34 the method for Structured assets has been simplified (no minimum 10% and no recovery rates), the structure is still very complex and, more importantly, incorrectly calibrated. The current Risk Weights are calibrated based on AAA level which corresponds to a 99.98 confidence level which is inconsistent with other modules being calibrated to a 99.5%. • The CRO Forum would be happy to provide the evidence that the proposed calibration based on the underlying assets is incorrect. We strongly propose that the methodology referring to the rating of the asset pool should be removed. We therefore propose a deletion of the method based on the rating of the underlying assets, and including methodology based on the rating the actual structured credit using CRO Forum proposal. (See marked up IM attached) • As expressed in previous contribution, we believe that shocks of the structured credit should be based on the actual rating of these instruments. The CRO Forum proposes that the stress tests from our Option1 based on the rating of the structured products are re-calibrated to be equivalent to the corporate bond stress tests multiplied by a scaling factor of 1 for investment grades (ie. applying directly the corporate bond stress) and a scaling factor of 1.5 for other ratings (ie. applying 1.5 x corporate bond stress for BB and ratings below). • We propose that maximum durations should equal the values in CEIOPS‟ final advice. (See marked up IM attached). • We continue to believe that the requirements for the insurance company to prove that the originator retains on a continuous basis a 5% economic interest in structured finance instruments (Art. SR7.2) is very difficult to apply in practice. Consequences with non-compliance are punitive. Covered Bonds: • The text proposes to have different treatments of rating of covered bonds under spread risk and concentration. This is inconsistent and contradicts the rating in CRD (no distinction between AAA and AA). We find that both 1A and 1B covered bond ratings should have a reduced spread shock of 0.6%. (See marked up IM attached) • We think that the very different design of covered bonds (safeguard mechanisms such as collateral pools) in different countries renders a more individual treatment more adequately. Thus, the shock levels for country-specific covered bonds (Pfandbriefe, UK covered bonds, foncière, cedulas, etc.) should be calibrated based on an analysis similar to the one carried out for the corporate bond. Similarly, the different design of hybrids has also impact on its classification into tiers such that there should be an analogous, more sophisticated and differentiated treatment of covered bonds regarding the spread risk. Mortgage Module: 28 June 2010 • We do not understand the logic of excluding the mortgage module. The fact is that many insurance companies have significant holdings of residential mortgage loans and that should be recognised in the implementation measures. Govies/ Treatment of Sovereign credit risk: • For the treatment of spread for govies, we note inconsistency between the cover memo (where it‟s written that EC has decided to remove that OECD govies should not be subject to spread risk, but ask to refer to the treatment in CRD – govies issued by a country with a rating A or lower should have a shock) and draft IM (that do not refer explicitly to CRD). • We propose that: • EEA govies (even if the rating is A or lower) should not be shocked • Sovereign bonds from non-EEA governments that invested to back liabilities in the same currency are exempted form shocks. • Sovereign bonds from countries considered as competent authorities (even with a rating A or lower), should not be shocked [eg. Korea is considered as competent authorities under CRD] • Sovereign bonds from non-EEA governments with a rating A or lower, should have spread shocks set equal of those of corporate bonds with a rating one notch higher. Concentration risk for bank deposits: It is unclear why insurers are required to consider concentration risk against bank deposits, the most liquid form of assets. Moreover, the criteria defined in the CO6(5), such as government guarantee schemes are usually reserved for consumer protection and hardly ever extended to industry. Therefore, the structure of the proposal gives very little chance, if any, to insurers to ever meet the criteria. In addition companies in general, including insurers, tend to build up a reserve of cash in times of stresses and the monies wait on the side lines waiting for the market to settle. This was clearly evident in the recent market upset. Therefore for an insurer to have to require further capital in times of stresses could result in elements of procyclicality being introduced into the SII framework. Moreover, as a “customer” of the bank, insurers should be sufficiently protected under the revised Basel III framework. Therefore to hold capital against a very liquid asset held in a bank governed by Basel III makes very little sense. Therefore we propose that bank deposits should not attract a concentration risk charge. IM35 - Health UR • In general, we recognise that this has been a really complicated process, due to the complexity and variety of the products over the various countries, and due to the limited availability of data, and we advise to continue the process of calibration in order to improve robustness of the calibration factors. • Health Risk Equalisation Systems (HRES) are now recognised, which is important. A positive aspect is also that the scope of the HRES is not limited to one Line of Business within Health, but may be applied broadly. • However the applicability is limited to the area of premium risk. In our opinion, this should also be extended to reserve risk. • We have seen no adjustment on the use of Undertaking Specific Parameters (USP‟s) in the standard formula. The industry is of the opinion that more credibility could be attributed to the use of USP‟s in the health segment. • The issue regarding segmentation of Health business is now included in IM 13, and is generally in line with what was asked by the industry. Segmentation remains a complex issue for health insurance across Europe, as there is a large variety of insurance forms that are covered under health. • On the calibration we should reiterate that because of the complexity and variety of this segment, there is an ongoing need to continue the process in order to improve robustness of the calibration factors. IM36 - SCR Simplifications Proposals for SLT health shouldn‟t be simply copied from life, since special risk measures i.e. CaR (Capital at Risk) or surrender value don‟t exist for SLT health. We suggest reworking the proposal and will come up with an alternative proposal to the EC. IM37 - Procedure For Updating Correlation Parameters It would be very burdensome for companies to report all quantitative data relevant to update all correlation parameters within the annual report to the supervisor. The CRO Forum suggests establishing - prior to a review by EIOPA of the correlation parameters in the standard formula - a joint industry and supervisors working group to ensure that appropriate quantitative information are provided to the supervisory authorities. 28 June 2010 IM38 - MCR There is a general issue regarding the calculation of the MCR. On the one hand, it has to be simple by following a linear approach and on the other hand, it has to be risk-sensitive in order to ensure consistence with the calculation of the SCR in order to enable an appropriate ladder of supervisory intervention. These objectives cannot be achieved at the same time sufficiently which is the reason why a cap and a floor is introduced in the calculation of the MCR. We observed that the current determination of the MCR lacks consistency with the calculation of the SCR even where consistency would have been possible to be ensured and all these issues will lead to an unjustified level of prudence leading to a more regular application of the 45% SCR cap in the calculation of the MCR. The main issues are as follows: Diversification The calculation of the MCR is based on a linear approach where presently diversification benefits are not accounted for. This will lead to an unjustified level of prudence leading to a more regular application of the 45% SCR cap. The solution of this problem would be to introduce a factor on every level of aggregation in the calculation of the MCR that represents the diversification benefits. This factor should be derived from the calculation of the SCR (standard approach). This approach would preserve the linear approach prescribed in the Directive and it would allow for diversification benefits in a prudent way as it is reasonable to assume that there are less diversification benefits at the 99.5%-quantile than at the 85%-quantile (MCR calibration target) due to non-linear dependence structures including tail- dependence. Deferred taxes The proposed method does not take into account loss-absorbing capacity of deferred taxes. Although the Directive allows for not using all variables mentioned in Art. 129(2), among them deferred taxes, omitting deferred taxes would introduce an inconsistency with the calculation of the SCR and thus introduce an unjustified level of prudence leading to a more regular application of the 45% SCR cap. The cover note of the Solvency Experts Group from 14 June 2010 does not provide any justification for omitting deferred taxes in the calculation of the MCR. We strongly propose to take the loss-absorbing capacity of deferred taxes into account. Internal models Currently, it seems that internal models are allowed to calculate the MCR. A reliable ladder of supervisory intervention can only be established when the MCR is calculated consistently with the SCR. Otherwise, the only consistency with the calculation of the SCR, when the latter is determined according to an internal model, would be the cap and the floor applied to the MCRlinear. Although the Directive only refers to capital add-ons, replacements of a subset of parameters or the use of an internal model in case where the “risk profile of the insurance or reinsurance undertaking concerned deviates significantly from the assumptions underlying the standard formula calculation” (cf. e.g. Art. 110) with exclusive reference to the SCR and not to the MCR, the calibration target of 85%-VaR referred to in Art. 129(1)(c) cannot be achieved by a standard formula MCR when it is already clear the standard formula SCR is not appropriate for the calculation of the undertaking-specific SCR. By insisting on a standard formula MCR in this case, the resulting MCR would be meaningless, the calculation would be necessary but irrelevant as generally the 45% of the (internal model) SCR cap would apply which then even would have to be explained by the undertaking by Art. 129(4). Inconsistent treatment of composite insurance undertakings The calculation of the MCR according to the standard formula is done by first adding all linear Minimum Capital Requirements and then applying the cap and the floor to arrive at the combined MCR whereas for composite insurance undertakings the cap and the floor are applied before aggregating the life and the non-life part. This treatment is inconsistent. As the formulas for calculating MCRNL and MCRL are less sophisticated than the formulas for calculating SCRnl and SCRlife, we propose to take over the approach currently proposed in MCR6 to the standard formula for the MCR in order to obtain some basic alignment between the intermediate MCR- and SCR-results. This means there should be a combined MCRNL and MCRL with caps and floors taken into account in Articles MCR3 and MCR4. IM39 - Equivalence The provisions have adopted wording in the criteria to be assessed that contain greater prescription than set out in the CEIOPS advice. We encourage the commission to maintain a principle based approach in the IM and use level 3 (subject to transparent consultation procedures corresponding to the standards of the European Commission) to identify the indicators proposed by CEIOPS, and subject to consutation, that will help assess whether the substance of a third country regime is equivalent. We have therefore proposed some rewording and removal of the third requirement under „System of Governance and Public Disclosure‟. 28 June 2010 It is important that it is clear that the objective of equivalence is to encourage convergence rather than achieve convergence to enable equivalence assessments to be dynamic while recognising the differences that may exist between different markets. The industry in its response to CP78 set out the need for a transitional to address concerns that key jurisdiction may not meet the criteria to be determined as equivalent and the failure to be equivalent could have material commercial implications. We encourage the Commission to set out clearly its proposal to address this concern and are prepared to work with the Commission to establish a workable solution that promotes convergence.
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