Gabriel Bernardino on four important Solvency II reforms

The chair of the European Insurance and Occupational Pensions Authority (Eiopa) talks to Christopher Cundy about the main proposals to amend Solvency II and what they hope to achieve

Eiopa published its final recommendations for Solvency II on 17 December, proposing a package of measures designed to tackle a range of issues with the EU’s prudential framework and help prepare the insurance sector for an increasingly challenging environment.

The authority went some way towards making the net impact of the changes neutral, from the perspective of how much capital insurers would need to hold.

But in the eyes of the industry, the proposals went too far; meanwhile, other observers said they did not go far enough in recognising the ultra-low interest rate environment.

Eiopa’s chair, Gabriel Bernardino, says the overall changes produce a “balanced outcome”. In conversation with InsuranceERM, he discusses four key areas of reform – proportionality, recovery and resolution, long-term investments and insurance guarantee schemes – the outcomes Eiopa hopes to realise, and how they will be achieved.

Proportionality

Bernardino describes the changes in how Solvency II would be tailored for smaller and less-risky insurers as a “paradigm shift”.

Some notable stakeholders, including Karel Van Hulle, had called for the right for proportional treatment to be included in the text of the directive, and Bernardino admits supervisors have not applied proportionality consistently. 

Eiopa has moved forward by creating a class of “low risk” insurers. Like the existing provisions, proportionality is defined around the nature, scale and complexity of the risks an insurer takes on – but the proposal has quantitative risk-based criteria to improve transparency.

Low-risk insurers will be relieved of certain governance and reporting requirements. For instance, they will only be required to compile the regular supervisory report (RSR) once every three years, instead of annually. Thresholds for the fulfilment of certain reporting templates are being increased.

“This will bring much more clarity to the process [of applying proportionality measures] and have a huge impact in terms of the number of companies applying the proportionality measures,” says Bernardino, adding the measures had the unanimous support of Eiopa’s board.

“All in all, I’m really satisfied. This process of reviewing Solvency II allowed us to have a look at proportionality and reduce significantly the burden on the industry while keeping the risk-based nature of the regime.”

Recovery and resolution

Eiopa’s plan to create a harmonised recovery and resolution regime dates back many years – its first consultation paper on the topic was launched in December 2016 – and the issue has been given fresh impetus by the Covid-19 crisis. 

Bernardino says not only is there a need to bring the EU framework up to international standards, but the inconsistencies on recovery and resolution across the member states has created problems.

“Nowadays, in modern prudential regimes, having pre-emptive recovery plans is the ‘basis of hygiene’ from a risk management perspective,” he says.

The patchwork of national regimes does not sit well with insurers' ability to conduct business across borders. “Every time you have a situation that touches on cross-border business, this creates a lot of issues,” Bernardino says.

"Every time you have a situation that touches on cross-border business, this creates a lot of issues"

The proposals will see insurers creating plans for when they hit difficulties and for how they could be resolved if these prove insurmountable.

Bernardino stresses proportionality will be observed. “We are not expecting and we are not advocating that all insurance firms will need to develop a fully-fledged resolution plan. This is [to be] applied with flexibility.”

He also notes the trigger for initiating a recovery process will be the existing Solvency II ratios; no additional triggers will be introduced.

Member states can tailor to the specifics of their insurers and markets, and they are free to go beyond the minimum harmonisation proposals.

“I am very positive this will see its way through the political discussions,” Bernardino says.

Long-term investments

Encouraging long-term investment by insurers and increasing the availability of long-term products to consumers have become political goals for the EU.

Low interest rates have reduced the attractiveness of long-term insurance products, but regulations forcing insurers to hold a high amount of risk capital against their assets are also contributing to this trend.

Bernardino says Eiopa’s twin objectives were improving the recognition of the current economic reality and correcting any “unintended consequences” that prevented long-term investments.

There are many details in the proposal, but Bernardino highlights five elements.

"This gives a clear signal that if insurers generate more illiquid liabilities, they will be able to make more long-term investments"

First, the treatment of interest rate risk in the standard formula, which corrects a failure to recognise the possibility of negative interest rates. Bernardino says correcting this is “fundamental for the protection of policyholders and the credibility of Solvency II”.

Second is the extrapolation of the risk-free rate curve. Eiopa has been gradually reducing the ultimate forward rate since 2018 to bring it more into line with economic reality. With that same goal in mind, the latest proposals introduce a new methodology for extrapolating the curve for all currencies.

“This is a fundamental issue for us in terms of making sure the regime remains fit for purpose,” says Bernardino.

However, the changes have a less dramatic effect on insurers’ solvency than Eiopa had previously proposed, such as moving the last liquid point from 20 years to 50 years. “We don’t believe that is reflected in the economic reality that we see right now,” he says.

The standard formula and risk-free rate curve reforms will both reduce the solvency capital ratios of firms, and as such there are measures to phase-in these two reforms. But the next three elements will also compensate for the capital hit, to a large extent.

Third is the volatility adjustment (VA), where Eiopa is proposing a new methodology that increases the application ratio and introduces measures to avoid the over-compensation issues. Firms will also benefit more from the VA if they have illiquid liabilities.

“This gives a clear signal that if insurers generate more illiquid liabilities, they will be able to make more long-term investments …. And also they are less affected by short-term fluctuations [in financial markets],” Bernardino says.

Fourth is the risk margin. Like with the VA, Eiopa’s proposal is intended to reduce the size and volatility of the risk margin for firms with long-term liabilities. “The parameters build up in way such that the more long-term liabilities you have, the more reduction will be there,” Bernardino says.

Fifth is the lower capital charge for long-term equity. In 2019, the European Commission introduced a specific asset class for long-term equity eligible for a 22% capital charge, approximately half that for normal equity holdings. 

However, the qualifying criteria were rather strict, so Eiopa is proposing to make them “much more open and flexible”.

Bernardino says the overall rationale behind the changes is “the more illiquid type of liabilities you’ve got, the more equity investments can be categorised in this long-term equity class” and benefit from the lower capital requirement.

“I think it will have a big impact. This will allow many more companies to categorise equity assets as long-term equity, for life and also for non-life, which is a novelty. It’s still a sound and prudent way of looking at calibrations, because it is linked to the nature of the liabilities,” he says.

The new rules should allow insurers to increase investment in the real economy, including in small and medium-sized enterprises, and permit insurers to play their role in the Capital Markets Union, he continues.

For instance, the rules will support the development of products with more flexible, terminal-type guarantees, such as the Pan-European Pension Product.

“It’s part of a framework that we believe can be conducive to have more allocation to equity-like instruments and also to develop products where the upside from capital markets can be given to policyholders,” Bernardino says. 

Insurance guarantee schemes

Several EU member states have mechanisms in place to protect policyholders should their insurer go bust. These typically involve financial compensation, which will allow them to purchase another policy, or the transfer of the policy to a solvent insurer.

"It's time the insurance sector in Europe had standards similar to what you have on the banking and investment funds side"

However, similarly to the recovery and resolution mechanisms, there is a patchwork of schemes that cause issues for Eiopa when it tries to deal with cross-border business failures, while some countries have no scheme whatsoever.

“It’s time the insurance sector in Europe had standards similar to what you have on the banking and investment funds side,” says Bernardino.

Again, as with recovery and resolution, Eiopa’s intention is to have a minimum harmonising rule, “based on the substance not on the form”.

Eiopa has defined a set of principles that such schemes should meet, and it will assess whether countries meet them. There will also be a transition period for countries to develop their fully fledged schemes.

“We know Solvency II is not a zero-failure system. There will be situations where companies go belly-up, so we need to ensure there are mechanisms to protect consumers,” says Bernardino.