Understanding Solvency II, What is different after August 2013
There is a real concern that the Financial Services Authority will try to gold-plate the standard formula approach, by seeking to add bespoke requirements and to load capital in some areas in which they are uncomfortable. This seems very inconsistent with the concept of a standardised approach, and suggests a back-door route to employing internal models, where the size or complexity of the firm does not warrant it.
As a result, firms may be forced to hold more capital, thereby reducing efficiency, and creating a competitive disadvantage against those insurers with an internal model, or from other European countries or further afield. This all reinforces that there is a real need for regulators to explore ways in which the regulations can be simplified where warranted, so that the same ends are achieved more cost-effectively in smaller insurers. Even more important, FSA and European regulations need to show greater leadership: there has been a subdued tone to messages issued by the regulator in recent months, both about the timeline for Solvency II and it's ultimately value.
Our research shows that mutual insurers remain committed to embracing Solvency II- if not with enthusiasm, than at least with a pragmatic desire to deliver the project on plan.
However this is at risk if regulators remain lacklustre in their own approach. In other aspects of the survey, three-quarters of AFM members now have staff actively working on their Solvency II implementation plan, whilst most of the remainder have completed their gap analysis and developed a resource plan- with detailed implementation waiting for regulatory certainty.
Eight per cent though indicated they have still to develop a detailed plan. In relation to the work being undertaken, the areas that mutuals are currently most focused on are risk governance systems, as well as embedding and use. The same Deloitte's survey suggested that implementation planning, as well as personal incentivisation and rewards, were the key priority at present; but for mutuals the review of incentive arrangements seemed to be of least concern.
Over half of AFM members see Solvency II as a strategic enabler, though only one firm describes it as the firm's overriding strategic initiative. Firms that regard Solvency II as less of a regulatory imperative are generally less confident that they are on plan to meet a deadline of January Within these views is the very real concern that the resources need to deliver the Solvency II work are also competing for resource with a host of other regulatory change.
Understanding Solvency II, What Is Different After July 2013
This includes the launch of the Retail Distribution Review, change to the tax and accounting regimes, the launch of new regulations, gender equalisation, with-profits regime change and a host of other European and UK initiatives. Regulators have shown scant awareness of the breadth of change affecting the insurance industry, and not done enough to co-ordinate or mitigate the impact of change.
One revealing aspect of the survey is that on the whole, there is quite limited concern amongst UK mutuals as to their capital position post-Solvency II. This reflects that the current capital regime in the UK is robust already, and that experience of quantitative surveys is that capital requirements will only change marginally under the new regime. It is also a reflection of the relative financial strength of UK mutuals: a report in this month's Money Management magazine indicated that the top eight life companies, based on free asset ratios, are all mutuals.
However, that is jeopardised by a failure by European regulators to agree on the finer detail of the regime, and to identify ways in which the rules can be properly simplified for smaller organisations.
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Solvency ii News January
Judging by premium volume, the global insurance market transfers asimilarly small share of accepted risk to other financial institutions andthe wider financial markets. Linkages with financial marketsArrangements designed to transfer risk out of the insurance sector createlinkages with other financial market participants. Securitisation, on the other hand, involves the issuance of insuranceliabilities to the wider financial market.
The counterparties are typically other financial institutions, such ashedge funds, banks, pension funds and mutual funds. Among insurance-linked securities, catastrophe bonds are the maininstrument for transferring reinsured disaster risks to financial markets. The exogenous nature of the underlying risks supports the view thatcatastrophe bonds provide effective diversification unrelated to financialmarket risk.
Possible Unintended Consequences of Basel III and Solvency II
For these reasons, industry experts had high expectations for theexpansion of the catastrophe bond market eg Jaffee and Russell ,Froot The issuance of catastrophe bonds involves financial transactions with anumber of parties Graph 7. At the centre is a special purpose vehicle SPV which funds itself byissuing notes to financial market participants. The SPV invests the proceeds in securities, mostly government bondswhich are held in a collateral trust. The sponsoring reinsurer receives these assets in case a natural disastermaterializes as specified in the contract.
Verifiable physical events, such as storm intensity measured on theBeaufort scale, serve as parametric triggers for catastrophe bonds. Investors recoup the full principal only if no catastrophe occurs. In contrast to other bonds, the possibility of total loss is part of thearrangement from inception, and is compensated ex ante by a highercoupon. Very few catastrophe bonds have been triggered to date. The Gulf Coast hurricanes activated payouts from only one of ninecatastrophe bonds outstanding at the time IAIS The global financial crisis has also dealt a blow to this market.
The year saw a rapid decline in catastrophe bond issuance,reflecting generalised funding pressure and investor concern over thevulnerability of insurance entities. The crisis also demonstrated that securitisation structures introduceadditional risk through linkages between financial entities. A case in point was the Lehman Brothers bankruptcy in September Four catastrophe bonds were impaired — not due to natural catastrophes,but because they included a total return swap with Lehman Brothersacting as a counterparty.
A further set of financial linkages arises with other financial institutionsthrough cross-holdings of debt and equity.
Insurance companies hold large positions in fixed income instruments,including bank bonds. At the same time, other financial entities own bonds and stocks ininsurance companies. Additional shareholders with direct linkages to the financial sector havebeen disclosed by a number of reinsurance companies. The ramifications of such linkages in this part of the market are difficultto assess.
This development has led to unprecedented losses for the globalinsurance market, where they cascade from the policyholders via primaryinsurers to reinsurance companies. Reinsurers cope with these peak risks through diversification,prefunding and risk-sharing with other financial institutions.
This global risk transfer creates linkages within the insurance industryand between insurers and financial markets. While securitisation to financial markets remains relatively small,linkages between financial institutions arising from retrocession havenot been fully assessed. It is important for regulators to have access to the data needed formonitoring the relevant linkages in the entire risk transfer cascade, as nocomprehensive international statistics exist in this area.
Although several important steps have been taken recently both at theEuropean and national level, uncertainty remains with regard to anyremaining implementation risks. In addition, the combination of austerity measures, risingunemployment and a prolonged period of subdued growth could havenegative effects on insurance demand.
Recent changes in asset allocation of European insurers rather hint at areduced risk appetite concerning credit investments.
They tend to shift investments towards less riskier counterparties,reducing their European sovereign and banking exposure. Market risks are still dominated by the low yield environment with 10year swap rates in Western Europe having again reached new lows in thepast months. Lapse rates in the sample have improved from their peak in Q4 andremained stable since last quarter.
In addition, implementation risks around the various crisis managementtools used in the sovereign debt crisis are non negligible. Improvements in other indicators, e. Other indicators remained stable. Conceptually, not so much, I would suggest — and nothing that cannotbe fully explained within standard models of finance. But in practice, and in particular in the euro area, two linked elementsthat were always potentially present or implicit have leapt intoprominence in a way and to an extent that was not foreseen.
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I have to admit to the possibility that my remarks may be subject tosome professional deformation here, in that my perspective on thesematters is likely coloured by my pre-occupation with the situation inIreland. Ireland has certainly displayed these two elements in a dramatic way,but they are evidently present in half a dozen other euro area countriesalso and to an extent which has had implications for the functioning ofthe Eurosystem as a whole, and therefore on the global financial system.
Let me take these two points in turn. Why did the default premium suddenly emerge?
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Evidently, even though everyone understood the rules, no such pricing-in occurred for the first decade of the Eurosystem Figure 1. Perhaps, despite Treaty prohibitions, market participants assumed thatany sovereign that got into trouble would be bailed-out. Indeed, sovereign spreads in the euro area were almost totally insensitiveto credit ratings before the crisis Figure 2.
One often-heard interpretation of what happened during that decade isthat the complacent market environment relaxed the budget constrainton euro-area sovereigns and led them to borrow recklessly. After all, although sovereign debt ratios in most of the Eurosystem didnot fall as much as they could and should have on the good years, atleast they did not increase dramatically before the crisis Figure 4.
Private debt ratios, and in particular the size of the bank and near-banksystems did increase, but that is a somewhat different story, to which Iwill turn shortly. Most likely, what we have seen is a combination of factors: i a sharp reduction in risk appetite resulting in even little-changed debtratios, as in Italy, looking more challenging and in need of a risk-premium; and in addition for most countries ii a sharp increase in debt ratios as governments reacted to the crisis including, but not at all confined to, the socialisation in most countriesof some private banking losses through their assumption bygovernments Figure 4 again.
The increased sensitivity of sovereign spreads to ratings, and theincreased range of ratings themselves — both illustrated in Figure 2 —suggest that both factors are at work. As spreads widened in stressed countries, their fluctuations — whichwould not concern hold-to-maturity investors — added a risk factor forothers and probably ratcheted up the average level of the spreads.
Even as late as April , after the first sampling indicated the scale ofthe banking losses, sovereign spreads were little more than 1 per cent. By November of that year just a few weeks after the Deauville statementwhich persuaded the markets that private sector holders of eurosovereign debt would not be immune from loss-sharing large bankingoutflows and spreads exceeding five per cent made recourse to officialassistance inevitable.
Figure 3 shows the plot with some relevant news stories flagged. Perhaps the most significant take-away from the sequence of spikes andtroughs is the fact that some of them clearly relate to news that iscountry-specific, some of them to euro area general news. The same is doubtless true for all of the stressed sovereigns. Default risk vs. On the contrary, they were the norm as is illustrated by Figure 1. The difference is that these spreads reflected a combination of defaultrisk and currency risk. During the last fiscal crisis of the s Irish sovereign spreads balloonedout also.
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But that was for local currency denominated debt. Eurobond borrowing by the Irish Government remained at fairly tightspreads despite the high overall debt ratio higher than today , and thefact that almost half of the national debt was denominated in foreigncurrency. The high spreads reflected devaluation expectations and currency riskgenerally.
And there were devaluations, though less than was baked into thespreads — by between and basis points on average during the lastten years of that ill-fated regime, the narrow-band EMS. It is not that default and devaluation are close substitutes; not at all, andfor several reasons.