The Advantages of a Global Solvency Standard

Strengthening the European supervisory landscape: Solvency II

The Solvency II project represents the ongoing efforts of the European Commission and various stakeholders to modernise the solvency regulation system for insurers and reinsurers in the European Union. Solvency II is designed to replace the current, simply structured European solvency regulations (Solvency I) with a modern, consistently risk-based system of financial supervision. This means moving away from a rules-based approach towards principles-based regulation in which companies’ risks are evaluated using risk-adequate and market-consistent—that is economic—criteria. As a result, risks can be assessed more precisely and promptly. These features show that Solvency II is good for consumers, putting the protection of policy-holders at the centre.

The Solvency II Framework Directive (Level 1 in the Lamfalussy process) was finally agreed in May 2009 by the European Parliament and the Economic and Financial Affairs Council. The derivation of the Level 2 implementing measures, which is being prepared by the European Commission on the basis of advice provided by CEIOPS, is the next step towards successful implementation in 2012.⁷ The industry and other stakeholders responded to the first and second wave of CEIOPS Consultation Papers in June and September, while the third wave is expected to be published in November, with responses due in December. Against the background of the financial crisis, it seems that CEIOPS is currently increasing the overall requirements and trying to introduce excessive prudence and conservatism into the Solvency II framework. These trends should not be accepted, as they contradict the initial spirit of the Level 1 framework directive. The industry must speak up now and raise its concerns in order to maintain the principles-based initial character, which seems to be in increasing danger of getting lost. If the direction that CEIOPS is advising is not changed, a solvency and supervisory system will emerge that places too great a financial and administrative burden on the industry and fails to fully encourage the right behaviour. As a result, consumers will be faced with a higher cost for insurance than might otherwise have been the case. This should sound the warning bells for European supervisors, as shaping Solvency II in this way might threaten the position of the insurance industry and the level playing field with other financial industries. Insurers should not be held responsible for developments in the financial crisis which they did not cause and which did not affect the insurance industry as much as it did others.

The current state of the U.S. supervisory system and related modernisation initiatives

Although the U.S. Federal Government maintains the constitutional authority to regulate the business of insurance and reinsurance, decades ago it delegated that authority to the 50 states. As a consequence, each state now exercises independent supervisory authority over the operations of companies that pursue insurance/reinsurance business within the state. Companies licensed in all the states must comply with the licensing and regulatory requirements in all 50 jurisdictions. This system has been increasingly criticised by national and international insurance/reinsurance organisations as being inefficient and in need of modernisation. Many have called for a more uniform, national approach to regulation. Currently, each supervisor participates as a member in the National Association of Insurance Commissioners (NAIC), a private organisation established in part to promote an appropriate degree of regulatory uniformity among the states. However, due to its private character, the NAIC lacks any legal authority to act as a national supervisor or to otherwise require the states to enact uniform regulatory standards.

Despite its lack of actual legal authority, the NAIC has played a leading role in designing, and encouraging the state supervisors to adopt, uniform solvency standards. At the centre of the quantitative standards is the Risk-Based Capital (RBC) Model, which was introduced by the NAIC in 1994.⁸ The model, which is generally uniform across states, provides a capital adequacy standard related to the main risks of insurers and requires insurers to set aside a safety capital buffer. Individual RBC models exist for life, health and property-casualty. The formulae focus on the main risk categories, meaning that it is not a comprehensive risk-based approach. Individual charges are factor based and result from multiplication of an underlying volume factor with the respective risk factor. The aggregation of the risk categories assumes that risk categories are either independent or fully dependent, which results in the simplest form of covariance approach.⁹ There is an incremental and targeted use of internal models (e.g. modelling of interest rates from fixed annuities, or a stochastic modelling approach for variable annuities with guaranteed benefits). Safeguards like the parallel application of standard deterministic scenarios or the requirement that the resulting capital charge from the internal model should not be unreasonably low must be considered in these cases. Finally, the resulting risk capital amount is compared with the insurer's available capital resources to derive information on its financial strength, which is translated into several levels of supervisory intervention.8

The U.S. supervisory process also includes requirements for periodic on-site examinations by the competent regulator, offsite financial analysis based on data reported by the insurer, and independent audits. From 2010 onwards, an enhanced risk-focused examination approach is to be in place which targets such issues as risk management and risk governance. NAIC procedures for the coordination of multi-state examinations have been developed and applied by the states, and other internal NAIC processes have been established for identifying and monitoring financially impaired insurers. Furthermore, insurers file their financial statements with the NAIC, and this information is made available to each state's supervisor. Regulatory disclosure comprises the above-mentioned requirement to file financial statements, which are stored on a central NAIC database. The information is used for benchmarking and peer-group comparisons.9

Notwithstanding the NAIC's considerable contributions to U.S. insurance solvency regulation, the recent financial crisis has prompted calls for further improvement of the U.S. system. In response, in June 2008, the NAIC announced a Solvency Modernization Initiative intended to investigate “[ … ] new ideas and an opportunity to create the globally pre-eminent solvency system … ”.¹⁰ Areas focused on in this initiative include capital requirements, group supervision and reinsurance.

In addition to the NAIC's Solvency Modernization Initiative, the U.S. Treasury recommended in its 2008 Blueprint for a Modernised Financial Regulatory Structure the establishment of an optional federal charter (OFC) for insurers.¹¹ The proposal advocates creating a system with responsibility for federal chartering, licensing, regulation and supervision for insurers, reinsurers and insurance producers (i.e. agents and brokers). The OFC would not be compulsory; insurers could still opt for the current state-based regulation instead of being regulated at the national level. States would not have jurisdiction over those electing to be federally regulated.

The NAIC itself has recently adopted a proposal for the modernisation of U.S. reinsurance regulation that has significant implications for both U.S. and international reinsurers. Under the NAIC proposal, reinsurers that are organised and licensed in qualified non-U.S. regulatory jurisdictions would be able to provide creditable reinsurance to U.S. insurers upon certification by a single U.S. “Port of Entry Supervisor”. The non-U.S. reinsurer would be able to apply for certification by any U.S. state that had been approved by a federal agency (the “Reinsurance Supervision Review Board”) as a qualified Port of Entry Supervisor. Similarly, U.S.-domiciled reinsurers would be allowed to transact business throughout the U.S. pursuant to a license issued by a single “Home State Supervisor”.

Like the U.S. Treasury's OFC proposal, the NAIC's reinsurance regulatory modernisation proposal would require federal statutory authorisation.

Advantages of a global supervisory approach

Without doubt, a global approach to insurance supervision would have several advantages for supervisors, insurance and reinsurance companies and their policy-holders. Many countries already have or are in the process of revising their regulatory systems to give them a more risk-based approach. These isolated endeavours, however, disregard an important point: increasing globalisation and internationally operating insurance and reinsurance companies with a wide-ranging network of branches and subsidiaries require a global supervisory standard.

Harmonisation of quantitative and qualitative regulatory standards is advantageous for all parties involved. The industry will benefit from the fact that only one standard has to be followed and resources do not need to be allocated so as to comply with numerous regulatory systems. This is of particular importance for companies which intend to expand into new markets abroad. The cost and resources issue should not be neglected on the regulatory side either. Having a uniform supervisory standard will save regulators money, as their staff can concentrate on one set of rules and requirements. Focusing on a single regime is also appealing in the light of regulatory standards and models that are becoming more complex and challenging, and which will require people with special skill-sets. The war for talent, that is the search for people with actuarial and risk management expertise, has already begun, and demand is still on the rise. Policy-holders and other intermediaries will also benefit from lower prices as a result of the emerging level playing field and thus increased competition between insurers and reinsurers and their lower spending for compliance with various supervisory frameworks. If policy-holders were to be asked, they would almost certainly advocate a globally consistent standard precisely for these reasons.

Transparency is another keyword in the current debate. Adherence to the same set of standards by companies worldwide minimises the risk of regulatory arbitrage. And a new standard geared towards the latest findings in the industry will avoid inefficiencies going forward.

Globally operating insurance and reinsurance companies play an important role in the development of national economies by assuming and disseminating risks and making entrepreneurial decisions. These activities, however, harbour the risk of spreading economic instability, which could be mitigated by having a global regulatory regime. Having such a regime would enable developed countries to demonstrate more effectively the existence of efficient and stable insurance markets against the background of the current volatile financial markets and a looming worldwide recession scenario. Supervisors will be better prepared for the occurrence of future crisis situations (e.g. the increasing probability of pandemics, the rising severity of natural catastrophes and terrorism alerts, to mention just a few).

Features of a future global solvency standard

Any developments towards a global supervisory standard have only a low prospect of success if they do not include the United States and the European Union, the world's two largest insurance and reinsurance markets. This section examines various factors that are potentially beneficial and important for a global solvency standard and looks at how the supervisory regimes in the U.S. and EU are currently dealing with them. This overview does not claim to be exhaustive, but it singles out some of the important factors.

Potential downsides from the pursuit of individual solutions

The failure to implement a global supervisory standard could have adverse impacts in increasingly integrated and interlinked insurance markets. The remainder of this subsection lists some of the most obvious points. The pursuit of stand-alone developments would inevitably create uneven regulatory playing fields. Fair competition is scarcely achievable in a situation of inadequate regulatory equivalence. This applies to various levels and stages in the regulatory process.

Different risk capital requirements for the same risk and the same amount of exposure are an adverse development, impeding fair competition and presenting a disadvantage for policy-holders. The same is true in respect of the admissibility criteria for own funds or available capital resources, which impact the capital mix of companies and the resulting return-on-capital requirements.

Diverse levels of supervisory requirements for risk management and for supervisory reporting and disclosure result in an uneven distribution of costs and resources. This favours companies acting under supervisory standards with relatively low requirements, while creating drawbacks for companies operating under more advanced regimes with more comprehensive requirements.

Lastly, the absence of group supervision creates severe disadvantages for globally operating insurance and reinsurance groups. Insurance groups would not be considered in terms of their capacity to efficiently employ capital and exploit regional diversification benefits. Rather, groups have to capitalise each entity according to the respective local regulatory capital requirements. Furthermore, groups cannot utilise the advantages of a lead supervisor who cooperates with a college of supervisors, but have to deal with each supervisory authority separately. Such a procedure leads to higher costs and inefficient utilisation of resources.

IAIS as global insurance supervisory authority

The previous sections have shown that the creation of a global supervisory standard for insurance is an ambitious but worthwhile undertaking. Apart from the availability of the regulatory standards and the readiness of the insurance and reinsurance companies, there remains the question of whether or not a regulatory authority with sufficient and adequate competencies and powers exists to ensure compliance with global standards.

The IAIS, which represents insurance regulators and supervisors worldwide, appears to be the best-suited candidate. The organisation was set up in 1994, and its main objective is the release of Insurance Core Principles (ICPs), other principles and regulatory standards. The ICPs present fundamental principles for proper regulation and deal, for example, with the supervisory system, prudential requirements or questions relating to the ongoing supervisory process. The ICPs have been accepted by IAIS members as an appropriate supervisory standard, but in practice companies must still comply with the local regulatory standards and requirements. IAIS Principles, Standards and Guidance Papers are currently non-binding, that is they are not directly applicable to (re)insurers but have to be implemented by IAIS members.

While there seems to be general agreement among stakeholders that the IAIS needs to be strengthened in order to achieve a global solvency standard in the mid to long term, there is still uncertainty about how exactly this could be accomplished. One option would be to restructure the IAIS into a WTO-like organisation with the power to issue binding guidelines and conduct appropriate dispute settlement procedures. It is also conceivable that the OECD Insurance Committee might play a more prominent role. Both options could be explored in more detail.

Many believe, though, that the most promising idea for insurance is to adopt a process similar to the one developed for the Basel Committee on Banking Supervision. The Basel Committee was established by the central bank governors of the G-10 countries in 1974. Interestingly, the Committee does not possess any formal supranational supervisory authority. Its conclusions do not, and were never intended to, have legal force. Like the IAIS, the Basel Committee formulates supervisory standards, guidelines and best practices. But usually banking supervisory rules are endorsed by the central bank governors and heads of banking supervision of the G-10 countries, as was the case with the Basel Accord 1988, Basel II in 2004 or the Revised Framework in 2006.

Without prejudice to the first two options and without going into the pros and cons of the different options, this last approach seems to be the most workable one, as it might be implemented within a reasonable period of time.