The Solvency II Framework Directive was adopted by the European Parliament in April 2009. Both before and since, CEIOPS (the Committee of European Insurance and Occupational Pensions Supervisors) has been developing proposals for more detailed rules to supplement the Directive. That process will continue this year and next, in time for the Solvency II regime to be implemented throughout Europe on 31 October 2012.
A key area of reform under Solvency II concerns the assets in which insurers and reinsurers may invest. The regulatory objective is clear: insurers and reinsurers should hold assets of an appropriate amount and quality to match their insurance and reinsurance liabilities plus their solvency requirements. So how is “amount” and “quality” to be regulated?
Amount
Under Solvency II, insurers and reinsurers will be required to hold assets equal to the sum of:
- technical provisions (basically, insurance liabilities);
- other liabilities; and
- the Solvency Capital Requirement (“SCR”, including any Capital Add-On imposed by the relevant regulator).
Clearly the calculation of the above elements drives the amount of assets required. Also important, however, is the issue of how the assets themselves are to be valued. Across the Solvency II regime, valuations are generally determined on a market-consistent basis. This is true of assets, which are to be valued at “the amount for which they could be exchanged between knowledgeable willing parties in an arm’s length transaction” (Article 74 of the Directive). As was apparent during 2007/8, rigorous market-based valuations of assets can create sudden downward spirals if the holders of such assets are forced to sell en masse into an illiquid market.
So how rigorous is the market-based valuation concept? CEIOPS says, in Consultation Paper 35, that valuations should generally follow IFRS where this leads to an appropriate economic value. Where there is an orderly market, mark-to-market valuations must be used to determine economic value. If there is no orderly market, mark-to-model valuations can be used (provided the model is thoroughly understood, periodically reviewed and is supplemented by observable market inputs). If multiple models are possible, regular independent valuations may be required. CEIOPS has also made the following more specific recommendations regarding asset values:
- goodwill on acquisitions should be valued at nil;
- the present value of future profits, such as VIF or PVFP, may be reflected as a reduction in technical provisions (subject to those rules), but not as an asset;
- investment properties should be valued at fair value (even if recorded at cost for IFRS purposes) and if independent valuations are used, they should be updated when significant market changes occur or at least every 3 years;
- investments intermediated through special purpose vehicles (e.g., subsidiaries or limited partnerships) should not be valued on a “look through” basis if there is a market in interests in the intermediary vehicle itself or if there are other intervening factors;
- contingent assets can be recognised only where their receipt is virtually certain, however contingent liabilities must be recognised where an outflow becomes probable; and
- deferred tax assets and liabilities should only be recognised where they are linked to other specific assets or liabilities in the Solvency II balance sheet (the effect is that unused tax losses should generally be valued at nil).
The above rules regarding asset valuation may reduce insurer/reinsurer demand for complex structured investments and hedges (mainly, over-the-counter derivatives). This is because such structures are often bespoke and therefore not able to be marked to any market. Accordingly, insurers and reinsurers will only be able to value such investments/hedges using models. That is consistent with current practice. What is new, however, is that models will be scrutinised much more closely by regulators, and insurers/reinsurers will be expected to master the models themselves (rather than delegating their development to external advisers or banks).
Quality
There are two main ways in which asset quality can be regulated. Either by stipulating a list of assets that may be held or by laying down general principles which are designed to achieve an appropriate level of overall prudence. The former approach can be seen in the existing Life and Non-Life Directives, which list out the categories of asset that may be used to back technical provisions. The latter approach may be seen in the existing Reinsurance Directive, which sets out broad principles regarding asset sufficiency, liquidity, security, etc.
The principles-based approach (as per the existing Reinsurance Directive) has been adopted in the Solvency II Directive. The main rule (in Article 130 of the Directive) is based on a “prudent person” test, which requires insurers and reinsurers only to invest in assets that they can properly identify, measure, monitor, manage, control, report and take into account in their ORSAs (own risk and solvency assessments, which can lead to a Capital Add-On above the existing SCR). There are also general rules about off-market products and diversification. Beyond that, there are no strict limits on asset or counterparty concentration.
As an overlay to the above, assets backing the SCR must be invested to ensure their security, quality, liquidity, profitability and geographic availability. Assets backing technical provisions must be invested to match the nature and duration of the insurer/reinsurer’s liabilities, and be invested in the best interests of all policyholders and beneficiaries (taking account of any disclosed policy objectives). Where policyholders take the investment risk (i.e., under linked policies), close-matching rules apply, as now.
Whilst the principles-based approach appears to provide welcome flexibility for insurers (and maintains the flexibility to which reinsurers are accustomed), it does also create flexibility for CEIOPS and the various local regulators and could give rise to some uncertainty. CEIOPS’s advice on asset allocation pre-dates the Solvency II Directive by two years (that advice followed Consultation Paper 19). Accordingly, CEIOPS will need to revisit this issue. According to CEIOPS’s work programme, it will give level 3 advice on the above asset rules toward the end of 2010. The only level 2 advice CEIOPS is scheduled to give before then in relation to asset allocation is in November/December 2009, concerning the requirements for insurers and reinsurers wishing to invest in securitised loan portfolios.
Conclusion
At this stage, it will difficult for insurers (and, to a lesser extent, reinsurers) to assess whether their assets will meet the new Solvency II rules. One hopes that insurers complying with existing asset rules under the current Directives will find that little needs changing to achieve the necessary level of prudence. However, the point will remain open until the final implementing measures are known (toward the end of 2010). For now, insurers and reinsurers should consider whether the tightened market-based valuation rules would affect their ability to continue investing in complex structured products.
For further information, please contact:
Tim Scott (tim.scott@linklaters.com, (44 20) 7456 4447).
