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					SOLVENCY II BULLETIN – Issue 15: The State of Play & Outstanding Issues
Solvency II: Future Positive
Last year was a tough one for Solvency II. Understandable caution from supervisors
in the light of the credit crisis re-enforced the less than understandable concern
about creating a more integrated European framework for prudential standards and
supervision. The various “waves” of CEIOPs advice gave vent to this with some
excessive calibration, and a silo approach to risk assessment at odds with the design
of the Solvency II framework. There is now real recognition of the problems this
created and a wish to find a more realistic way forward that uses market valuations,
and ditches the old and entirely dodgy book and historic cost numbers. In doing this
the insurance industry has put itself a generation ahead of the Basel regime for
banking- even in the recently launched Basel III amendments. The challenge
remains to avoid watering down Solvency II in development and implementation and
stick with its market consistent design. Although some major issues remain, the
recognition or not of third country regimes for example, there is still momentum
around the project and a real likelihood of success.
In this issue we discuss the next steps for Solvency II, key developments at level 2,
key issues for QIS 5 and we also provide a short analysis on third country

1. The Commission brings pragmatism and purpose to bear on Solvency II

Following CEIOPS’ final advice for the level 2 implementing measures, the European
Commission now has ownership of the drafting of the measures in consultation with
Member States through the Solvency Experts Group (SEG) and key industry
stakeholders through a more informal process. The ABI is therefore actively engaged
both at a national and European level, providing input and feedback to those who sit
at the SEG meetings, and to the CEA which has been asked to provide feedback on
the draft proposals by the Commission.
Simultaneously, CEIOPS is preparing the draft technical specifications for the
Quantitative Impact Study (QIS) 5 exercise which will be held across Europe from
end July until October 2010. Based on their final advice for the level 2 implementing
measures, CEIOPS will be sending the QIS 5 technical specifications by end March
2010 to the European Commission who will be again consulting key industry
stakeholders until end May before the final specifications are released in July.

2. The Commission's proposals for level 2

The Solvency Experts Group has met five times, between early December 2009 and
end March 2010, to discuss the Commission’s draft proposals for the level 2
implementing measures. So far, the Commission has prepared and revised the
following level 2 implementing measures (IM):
    Ref                     Description of issues                         version
    IM1    System of governance                                              Yes
    IM2    Public disclosure                                                     Yes
    IM3    Valuation of assets and liabilities                                   Yes
    IM4    Approval of the use of an internal model                              Yes
    IM5    Tests and standards for internal models                                -
    IM6    Ancillary own funds                                                   Yes
    IM7    The classification and eligibility of own funds                        -
    IM8    Transparency and accountability of supervisor                         Yes
    IM9    Supervisory reporting                                                  -
   IM10    SPV authorisation                                                     Yes
   IM11    Calculation of group solvency                                          -
   IM12    Capital add-ons                                                        -
   IM13    Technical provisions                                                   -
   IM14    Extension of the recovery period                                       -
   IM15    Symmetric adjustment - equity risk                                     -
   IM16    Duration based -equity risk                                            -
   IM17    Treatment of participations                                            -
   IM18    Repackaged loans investments                                           -
   IM19    Simplified methods and techniques to calculate technical               -
   IM20    Technical provisions                                                    -
Whilst this is still early days, key changes have been introduced compared to
CEIOPS’ draft and final advice, in particular:
   ·       Future premiums (irrespective of whether it increases or decreases the
   TP) recognised in principle (IM 13)
   ·       Diversification is to be taken into account at the level of the portfolio in the
   calculation of the risk margin (IM 13)
   ·       Several references to proportionality and materiality have been introduced
   across the board in order to reduce the regulatory burden based on the size of a
   subsidiary or a business line (IM 2, IM 6, IM 9, IM 10)
   ·       The basic risk free rate will be derived from the swap rate adjusted for
   credit risk (IM 20)
   ·       A 12 year transitional measure has been introduced for the calculation of
   the risk free rate for annuity providers on business in force prior to Solvency II
   implementation (IM 20)

The Solvency Experts Group (SEG) will continue to meet until June 2010 inclusive,
to discuss outstanding issues and upcoming draft proposals from the Commission.
The next meeting of the SEG is scheduled for the 29th – 30th March and will notably
cover: the risk free rate and the liquidity premium (IM 20), the Pillar I dampener (IM
15), duration based equity risk (IM 16), Participations (IM 17), repackaged loan
investments (IM 18).
Whilst some highly significant changes have been introduced in the
Commission's level 2 implementing measures, we must continue to press for political
support across Europe to ensure these positive changes are agreed by Member
States who in many cases delegate their representation to the same supervisors
involved in preparing the original CEIOPS advice. In addition, there are further
issues where we are keen to secure progress, including the calibration of the SCR,
market risk, Non Life and Health risks; the MCR; intra group transactions; partial
internal models; group solvency; entity specific parameters; third country

3. What QIS 5 will need to achieve

QIS 5 will constitute a live test exercise of the Solvency II framework and the detailed
technical implementation. We will therefore need to ensure the final technical
specifications of this exercise are set appropriately.
The ABI and other European organisations, such as European Insurance
Association (CEA) are therefore committed to working with the European
Commission in a fundamental re-calibration of the CEIOPS advice, before the QIS 5
exercise is launched. In particular, we believe the following areas will need to
undergo considerable changes to ensure Solvency II becomes a real step forward
for the European insurance industry and its customers:
  Description of             What needs to be achieved                Has this already
     issues                                                            been resolved
                                                                           in the
                                                                         draft IM?
Future Premiums Future premiums need to be recognised as
                                                                          Yes, IM 13
                   tier 1 capital
Risk free rate     It needs to be based on the swap rate
                                                                          Yes, IM 20
                   adjusted for credit risk
Liquidity Premium It is appropriate to distinguish these liabilities,
                   enabling insurers to recognise the higher
                   returns available on illiquid assets used to           Yes, IM 20
                   support these liabilities and hence offer
                   customers a better return
Risk margin        Diversification should be recognised in the
                                                                          Yes, IM 13
                   calculation of the risk margin
Calibration of the CEIOPS advice significantly increases
SCR –              underwriting risk factors. In particular,
                                                                       Commission draft
underwriting risk diversification for size and for geography
                                                                      IM not yet available
                   have been ignored, despite clear evidence.
                   This is hugely damaging for the GI sector
Calibration of the The risk factors have been significantly
SCR – market risk increased and the correlation factors are too
                                                                       Commission draft
                   conservative. This must be carefully reviewed
                                                                      IM not yet available
                   to ensure that the calibrations are not
                   permanently fixed at “crisis levels”
Own Funds          CEIOPS advice provides only limited                 Commission draft
                   recognition for hybrid instruments and place IM not yet available
                    too many own fund items into Tier 3, with a
                    very low 15% limit. The Commission must
                    ensure that the definition of hybrid
                    instruments is not too restrictive; there must
                    be an appropriate split of own fund items
                    between Tier 2 and 3 (not all in Tier 3); the
                    Tier 3 limit should be raised back to the Level
                    1 suggested 33%; specific and detailed
                    grandfathering of current instruments is
 Participations      CEIOPS advice is based on the
                     unreasonable assumption that fund
                     managers and banks are valueless and
                     place strict limits on the recognition of
                     surpluses arising in individual insurance
                     entities across the group. This will
                     substantially reduce own funds; frustrate      Commission draft
                     effective group capital management; and          IM not yet
                     introduce arbitrage between the balance           available
                     sheet and the regulatory requirements.
                     However, CEIOPS has recently indicated a
                     shift and agrees with the industry position of
                     using an equity value approach. Provided
                     that QIS5 reflects this approach, no further
                     action is required.

4. Spotlight on equivalence

Regarding equivalence the following three issues are key:

   ·      Which countries are likely to be obtain the equivalent status
   ·      What will be the consequences of non equivalence
   ·      The treatment of multinational groups

Key Markets

Our tentative importance ranking of non EU countries would be: Switzerland, US,
Bermuda, Canada, Australia, Hong Kong, India, China, Japan, Guernsey. It is
however very likely that there will be a significant gap between this ranking and the
likelihood of these countries obtaining equivalence.

To summarise:

   ·     Switzerland is the closest regime to Solvency II and most likely to be
   considered equivalent.
   ·     Japan, Canada and Australia have a risk sensitive framework and might be
   granted equivalence with a few adjustments to their current rules if they decide to
   apply. Japan is unlikely to apply in the first wave as it is currently reforming its
   regulatory framework.
   ·      Bermuda is undergoing a profound reorganisation and is aiming to be
   equivalent with both the US and Solvency II. This is a serious challenge and the
   results remain to be seen.
   ·      Hong Kong, India, Guernsey and China still have a traditional system and
   are unlikely to be considered for the first wave unless they transpose the directive
   directly (which could be an option for Guernsey).
   ·      Whilst the US do not have a federal with which to negotiate and the State
   rules are somewhat dated, they remain a key market for many EU insurance

Consequences of the absence of equivalence

Bermuda is critical for reinsurance particularly for the UK. A significant share of the
business in the London market is also done with the US. The risk would be to see a
reduction in cross border transactions with companies opening subsidiaries in third

However it is very difficult to consider the consequence of non equivalence without
knowing what measure will be required in case of non equivalence and whether any
transitional measure will be applicable.

Treatment of cross border groups

The group approach of Solvency II could mean that overseas subsidiaries of EU
groups could be competitively challenged against local insurers and may therefore
be priced out of some markets. There is a possibility that EU-based groups will be
forced to re-structure and move their head office outside the EU which is not the
outcome the Commission or the industry want to see.

For non EU groups operating in the EU we need more details on the modality of
application of the EU sub group principle. In particular clarification is needed on what
will be the extent of EU regulators supervisory power beyond the EEA subgroup and
what level of reporting will be required.

For feedback and comments on this bulletin, or to be added to the distribution list
please email or call him on 020 7216 7411.

Peter Vipond
Director of Financial Regulation & Taxation


Ulrich Zink
Policy Adviser, Wholesale and Re-insurance
020 7216 7635

Paul Barrett
Assistant Director, Financial Regulation & Taxation
020 7216 7636

Emir Mujkic
Policy Advisor
020 7216 7354