Solvency II, the Europe-wide risk-based supervisory regime, has stood the test and should therefore remain in place – this was the provisional appraisal of the European Insurance and Occupational Pensions Authority (EIOPA) at the end of last year. So, business as usual then? No. In its Opinion on the 2020 review of Solvency II, EIOPA recommends that the European Commission take specific steps to strengthen the supervisory regime in several places.

It was already clear when the framework entered into force at the beginning of 2016 that the effectiveness of its individual elements would be scrutinised after several years. In a call for advice in February 2019, the European Commission asked EIOPA to issue an opinion, which the industry generally refers to as the Opinion on the 2020 Review. The coronavirus pandemic delayed its release by six months but it is now here in all its complexity.

BaFin has approved the Opinion as a whole. From BaFin’s point of view, it was important that the long-term guarantees that are typical in the German insurance industry continue to be possible in the even more market-oriented regime envisaged in the review. BaFin also argued for reporting to be more risk-based and for the proportionality principle to be implemented more systematically.

The key topics covered in the review also include the national insurance guarantee schemes (IGS) and issues surrounding recovery and resolution, as well as the inclusion of macroeconomic elements in the supervisory framework. As is typical of a compromise, BaFin managed to achieve some of these goals but had to give ground on others.

Long-term guarantees

Of great significance are the measures for long-term guarantees (LTG) that life insurers, for example, provide to their customers. One of the objectives of the review was for these guarantees to be incorporated into the provision for long-term contracts in order to more adequately take risks into account, also in view of the low interest rate environment. In the German market, the most important LTG measures include the extrapolation of the risk-free interest rate term structure, the volatility adjustment and the transitional measures set out in sections 351 and 352 of the German Insurance Supervision Act (Versicherungsaufsichtsgesetz – VAG).

Extrapolating the risk-free interest rate term structure makes it possible to recognise provisions for insurance contracts whose terms extend further into the future than reliable capital market information on risk-free interest rates. Since sufficient long-term bonds are not available, a last liquid point of 20 years has applied to date – from this point, extrapolation starts, i.e. observable and reliable interest rate data is used to draw conclusions about uncertain interest rates for which there is no reliable data.

The proposed extrapolation method requires insurers to factor in new market information, also beyond the starting point of the extrapolation. This would increase market consistency and ensure that the interest rate term structure remains stable enough to avoid excessive volatility in the technical provisions and solvency position. An additional “emergency brake” mechanism is aimed at ensuring that the amount of the provisions remains manageable for undertakings in the industry, even in difficult market situations.

The basis for this mechanism is the situation at the end of 2019. At the time, the net effect was more-or-less balanced in terms of positive and negative effects on capital. In the case of low interest rates, the mechanism kicks in and limits the adverse effects of the extrapolation, ensuring that there is a balance between positive and negative effects. However, the mechanism is temporary in nature. At low interest rates, the proposal will therefore place a burden on the capital of German undertakings until final implementation of the new extrapolation method.

The new extrapolation method is a compromise: some representatives of national competent authorities (including BaFin) saw no need for modification, while others advocated a significantly later last liquid point. The additional capital requirements make it likely that the proposal will give rise to debates in the political negotiations at EU level.

If EIOPA’s proposal is approved, the volatility adjustment (VA) will be better aligned with the objectives of the adjustment. The new VA is aimed at better taking into account the illiquidity characteristics of liabilities and at ensuring a quicker and more efficient response to turbulences on the financial markets. Those aspects make it simpler to offer long-term guarantees, and BaFin consequently sees their incorporation in the EIOPA Opinion as a success.

EIOPA proposes that insurers better inform professional readers in their solvency and financial condition reports (SFCR) of the transitional measures that they use (see expert article on the BaFin website dated 29 March 2021). Back in early 2016, the transitional measures were conceived to ease the transition from Solvency I to Solvency II. And in its current Opinion, EIOPA takes the view that national competent authorities should no longer issue blanket approval of new applications. For example, if an insurer suddenly finds itself having to rely on the transitional measures five years after Solvency II has entered into force, the national supervisory authority should look into the matter.

In addition to the LTG measures, EIOPA makes further recommendations for Pillar 1, where Solvency II stipulates own funds requirements. For example, EIOPA proposes to successively reduce future capital requirements within the risk margin to reflect the fact that the probability of recurrence declines once a risk has occurred. This would significantly reduce the risk margin and thus provide capital relief.

Capital requirements

In BaFin's view, recalibrating interest rate risk is the most important recommendation made by EIOPA with regard to the standard formula that insurers use to calculate their solvency capital requirement (SCR). This would remedy a technical shortcoming in Solvency II, since the standard formula has so far not taken into account the existence of negative interest rates. By contrast, the shift approach now proposed maps negative interest rates well, resulting in the actual interest rate risk finally being reflected more appropriately in the SCR. However, this proposal would also impose a burden on undertakings.

The technical proposals that EIOPA has made with the intention of increasing the risk sensitivity of the standard formula comprise recalibrating the market risk correlation between interest rate risk and spread risk, partially recognising retrospective non-proportional reinsurance in non-life reserve risk, and strengthening the effective transfer of risk to reflect risk mitigation techniques.

If EIOPA’s proposal is approved, national competent authorities such as BaFin will require insurers to prepare a finance scheme as soon as they are merely at risk of non-compliance with the Minimum Capital Requirement (MCR). In this situation, the supervisory authorities will be required to actively examine whether to restrict or prohibit the free disposal of assets. It must then be stipulated in Level 2 which minimum actions supervisory authorities must take in the event of imminent MCR non-compliance and what the minimum content of the finance scheme must be.

Thresholds and proportionality

To reduce the burden on low risk profile insurers – i.e. mostly small undertakings – EIOPA has pursued two regulatory approaches that BaFin welcomes and supports: thresholds and proportionality. EIOPA is in favour of increasing the Solvency II exclusion threshold in Article 4 of the Solvency II Directive and proposes a future relevant threshold of EUR 50 million in technical provisions. It is envisaged that – under certain conditions – Member States will be able to raise the threshold for annual gross written premium income up to a maximum of EUR 25 million. In Germany, this would likely benefit a notable number of smaller undertakings which would then revert to Solvency I.

Low risk profile insurers are to be allowed to consider as minimum requirements a series of statutory requirements that can be used to apply the proportionality principle. This would set them apart from medium to high risk profile insurers. Nevertheless, insurers with a higher risk profile are to benefit from the simplified procedures as well, but only with BaFin's consent.

Simplifications in Pillar 1...

Simplifications are to be introduced in all three pillars of Solvency II. In Pillar 1, insurers determine their best estimate, which is an integral part of their technical provisions. EIOPA intends to reduce the requirements for their stochastic valuation, where permitted by the risk profile. Another proposal is the introduction of a simplified methodology to calculate immaterial risk modules within the standard formula that contribute little to overall risk.

EIOPA also intends to make it easier for low risk profile insurers to perform the stochastic valuation of options and guarantees. Since guarantees also include interest guarantees under life insurance contracts, BaFin considers this recommendation to be inadequate for German life insurers, which are not low risk profile undertakings.

EIOPA also details how insurers should factor the contract boundaries within their portfolios and assumptions about future management actions and expenses into the calculation of their technical provisions.

…and in Pillars 2 and 3

As regards the governance requirements under Pillar 2, many of the new measures are already covered in the Minimum Requirements under Supervisory Law on the System of Governance of Insurance Undertakings (Mindestanforderungen an die Geschäftsorganisation – MaGo). As a result, the majority of these measures serve merely as clarifications for supervisory practice in Germany. For instance, EIOPA refers to the opportunity for low risk profile undertakings to combine key functions, to combine key functions with operational functions, or to combine being a key function holder with management board membership. In Germany, this is already permitted based on the established interpretation. What is also new in Germany is the proposal that insurers with a low risk profile will no longer be required to review their written internal policies on an annual basis but rather every two or three years. Undertakings are to conduct an own risk and solvency assessment (ORSA) only every two years, not annually.

BaFin also supports further Pillar 3 simplifications to be made in the area of reporting. EIOPA recommends introducing risk-based thresholds for quantitative reporting. In future, undertakings would only submit non-core templates if they exceed the risk-based threshold determined for the reporting template. The new thresholds would be more tailored to the specific undertaking since they consider the characteristics of the relevant business model more precisely. The result would be more risk-based and above all less time-consuming submission practices for undertakings. The solvency and financial condition report (SFCR) and regular supervisory report (RSR) are to be slimmed down and the SFCR is also to be made more suitable for its target audience. In future, the SFCR is to comprise a two-page summary for policyholders and a more detailed part for professional readers. Expanded requirements are also planned in specific areas, such as sensitivity analyses for key indicators at undertakings relevant for financial stability purposes.

EIOPA also intends to simplify the supervisory reporting templates; some are to be deleted. On the other hand, gaps in the reporting package are to be closed, e.g. with EIOPA collecting data on cyber risk with the help of the national competent authorities. The quantitative reporting requirements for internal models are to be expanded, in some cases significantly. Some deadlines for qualitative and quantitative reporting are to be extended.

Group supervision

Solvency II embodies a supervisory model under which the national competent authority responsible for the ultimate parent undertaking also supervises the group in question. However, if a subsidiary has its registered office in another EU Member State, the subsidiary is supervised by the local authorities as a solo undertaking. This has occasionally led to inconsistent approaches, which is why EIOPA has taken a closer look at some regulatory areas.

In the past, there have repeatedly been significant differences between Member States with respect to the scope of group supervision. In its Opinion, EIOPA has revised the definition of the term “group” and has developed an overall approach for group supervisors' options not to include individual undertakings in their supervision.

In EIOPA’s view, holding companies must also be included in the SCR and MCR at group level. If the capital requirements at group level are calculated by combining the accounting consolidation-based method and the deduction and aggregation method, double counting is to be avoided and no material risks are to be overlooked. As regards the application of partial internal models at group level, EIOPA also recommends demonstrating and documenting the appropriateness of integration techniques more clearly than has previously been required.

To date, the classification of own-fund items at group level has not been uniform across the EU. EIOPA's clarifications work towards ensuring that the requirements are applied consistently. For instance, groups are to justify the availability of expected profits in future premiums (EPFIPs) at group level. The generally undisputed inclusion of transitional measures at group level is to be documented in a reconciliation that also calculates the solvency ratio without the benefits at group level.

EIOPA also proposes a specific, uniform method that insurers can use to calculate the minority interests they are required to deduct from consolidated group own funds. In EIOPA's view, it should be clarified that groups must include in the calculation of group solvency their holdings in companies from other financial sectors with their sectoral own funds or capital requirements.

In relation to governance issues, EIOPA is in favour of removing all room for interpretation and clarifying that the ultimate parent undertaking is responsible for compliance with legal and administrative regulations at group level.

From BaFin's point of view, the proposals are adequate and appropriate to address existing gaps in the regulations and legal uncertainties and to ensure more effective supervision of insurance groups in the EU.

Macro-prudential instruments

To date, Solvency II has only provided for the risk-based solvency supervision of individual insurance undertakings. EIOPA is now proposing that the macro-prudential perspective be incorporated into the framework in addition to the micro-prudential perspective. Moreover, national competent authorities are to have the power to set capital add-ons for systemic risk and to prohibit distributions such as dividends. EIOPA is also proposing that the national competent authorities use the ORSA for macro-prudential purposes and be able to expand their risk and liquidity management requirements to include macro-prudential aspects. So far, EIOPA has only provided a rough outline of the instruments; in BaFin’s view, these require further development.

The next steps

The Opinion was submitted on 17 December 2020. The European Commission must now address the recommendations and then make its own proposal to the European Council and the European Parliament; this is expected to take place in the third quarter of 2021. In addition to the requisite modifications to Solvency II, the focus should be on the balance of the package as a whole. This will be followed by trilogue negotiations and it is uncertain how long these will take.

The coming issues of BaFinJournal will address national insurance guarantee schemes (IGS) and the recovery and resolution framework for insurers.