e-alert:

CEIOPS releases final advice on third wave of consultation papers

9 February 2010

On 29 January 2010, CEIOPS delivered its final advice to the European Commission on the vast majority of areas covered by the third wave of consultation papers for Solvency II Level 2 Implementing Measures. Consultation on this third wave of papers ran from 2 November to 11 December 2009. The final advice on the calibration of the SCR standard formula for health underwriting risk, non-life underwriting risk and the calibration of the MCR has been delayed to enable CEIOPS to collect further data from Member States in order to do further analysis for these calibrations. CEIOPS plans to have the revised advice on these topics in time for the draft QIS5 technical specifications, which should be released at the end of March 2010. We understand that CEIOPS will prepare the draft QIS5 technical specification in line with the final advice except in those areas specified by the European Commission (for example, in respect of the determination of which future premiums may be included in the technical provision calculation) and that the conclusions of the Illiquidity Premium Task Force will also be incorporated (CEIOPS has requested a small extension to the original 31 January deadline for the initial report to allow the Task Force to continue to make progress on key issues relating to the discount rate).

This e-alert briefly summarises some of the main changes contained in the final advice on the third wave and CEIOPS’ accompanying Feedback Statement. Overall, the most significant changes made were in relation to the calibration of the market stresses for the SCR standard formula and the correlation assumptions. In a number of cases the final advice is unchanged from the consultation papers, but there is further justification of CEIOPS’ reasoning. The impact of the final advice on the Level 2 implementing measures will be tested during QIS5 later on this year.

Summary of main changes to final advice

• Correlations - CEIOPS has conducted further statistical analysis to derive the correlations between risks and, in particular, has introduced two-sided correlations for interest rate risk depending on whether yields-up or yields-down is the most onerous. If the yields-up stress is biting the correlations between interest rate risk and each of equity, property and spread risk are now zero. The correlation between property and spread risk has been reduced from 0.75 to 0.50, as have the correlations between concentration risk and the other risks (from 0.75 to 0.5), although many will regard this latter correlation as still too high. There have also been some reductions in the correlations in the life underwriting risk module from 0.25 to zero. Correlations for health risk have also been specified but the structure of the health module may be subject to further changes. The final advice no longer suggests increases to the Basic SCR correlations specified in the Level 1 text. Overall, these changes will lead to an increase in diversification benefits but total capital requirements are still expected to be significantly higher than QIS4 (CEIOPS estimates 21% higher for life insurers (was 24%) and 9% for non-life insurers (was 13%) on average). 
   
• Equity risk - the main changes compared to the draft advice in CP69 are that the stress for "other" equities has been reduced to 55% (from 60%) and the volatility shock has reduced from 60% to 50% (although, unlike the new interest rate volatility shock, it is still a multiplicative stress and so may generate instability/procyclicality in extreme market conditions). Also the equity volatility shock is now assumed to be only 75% correlated with the equity price shock. The averaging period for the symmetric adjustment mechanism remains at 1 year despite calls from some stakeholders to increase this period to 3 years due to a lack of evidence that particularly supported a longer period.
   
• Market risk - the interest rate stresses have been reduced from those shown in CP70 (and are now weaker than those applied in QIS4 with the exception of the interest rate down stresses for shorter durations) and the volatility shock is now specified as an absolute (rather than percentage) stress of either 12 percentage points up or 3 percentage points down. The interest rate stress and the volatility stress are now assumed to be uncorrelated. The property stress has been simplified and is set at 25% for all property types (where previously city offices, warehouses and retail had a 30% stress test attached to them). The credit spread shocks for corporate bonds have been reduced and are now much more in line with current ICA stresses used in the UK and many companies economic capital models, although they are still significantly higher than those stresses applied in QIS4. The shocks have been derived by analysing CDS rather than corporate bonds, which may add some complexity when determining how the spread risk module might need to be adapted to incorporate an illiquidity premium in the risk free discount rate used to value some liabilities. There is now also a separate calculation for mortgage loans. The reduced interest rate and credit spread stresses and the introduction of the separate mortgage loan stress are very positive outcomes for the European insurance industry.
   
• Treatment of participations - the advice given by CEIOPS in this area remains largely unchanged which may come as a disappointment to the insurance industry. Some additional wording has been included for clarification, for example, the revised advice clarifies why CEIOPS did not recommend the ‘look through’ approach favoured by respondents. With regard to the treatment of non-financial and non-regulated participations, CEIOPS have revised the advice to make it clear that the "equity shock" is based on the economic substance of the participation. CEIOPS has provided more clarity on the participations in intermediate holding companies, which according to the revised advice, should be treated as financial institutions. However, if the participation is an insurance holding company, it should be treated as if it is an insurance undertaking. The final advice, if adopted under Level 2, may trigger some restructuring by insurance groups.
   
• Repackaged loan investments - the principles set out for investment in repackaged loan investments have changed very little and the proposals continue to impose potentially onerous compliance costs on both issuers and investors in securitised loans. Several stakeholders commented on the practical difficulties that insurers would face in carrying out the required due diligence and monitoring the requirement for originator/sponsor to retain a 5% economic interest. However, CEIOPS has maintained its position and responded that insurers who found the requirements too onerous may choose not to invest in repackaged loans. The most significant additions are clarifications on the consequences of breach of requirements and grandfathering. If the requirements for investment in a repackaged loan are breached then the expectation is that the insurer should inform its supervisor and seek to dispose of its holding, although the advice concedes that this may not be possible at a reasonable price within an appropriate timeframe, in which case further actions should be explored such as imposing a capital charge. To maintain market discipline, insurers are expected not to enter into future business with originators that have failed to meet the requirements placed on them. In the section on grandfathering arrangements it is clarified that the scope of the principles applies to repackaged loan instruments that are either issued on or after 1 January 2011 or that are issued before this date but where the underlying exposures are changed after 31 December 2014. 
   
• Extension of the recovery period - CEIOPS' initial advice recommended a maximum extension period of 30 months in total and despite the fact that a number of respondents considered that the maximum timeframe should be longer, CEIOPS could see no sufficient justification to change their original recommendation. CEIOPS also specified a range of external and internal factors to be taken into consideration when granting an extension and their final advice includes two further external factors: the availability of an active and liquid market and the potential detrimental impact on policyholders. There were a number of requests for clarification on the details and ensuring consistency across supervisors which CEIOPS acknowledges to be important but feels fall under Level 3 guidance rather than Level 2. 
   
• Treatment of ring-fenced funds (RFFs) - CP68 set out in some detail alternative definitions of RFFs. Following feedback, the final advice has been pared back to set out only the high level principles of RFFs. CEIOPS proposes that more details will be provided in Level 3 guidance but notes that it will have to respect national legal, insolvency and contract law and product regulation. This indicates that individual supervisory authorities may very well have a strong role in determining what is a RFF or not. CEIOPS has clarified the definition of RFF to exclude unit linked and reinsurance business provided that these do not exhibit any specific features over and above what is generally understood. A new principle has been introduced to cover internal or partial internal models relating to RFFs which states that the model must allow for the restrictions of the RFF. CEIOPS has also included a specific provision to reflect the shareholder element of profit sharing arrangements under an RFF (e.g. a 90/10 fund). 
   
• Undertaking specific parameters - a number of alterations have been made to the final advice in this area but the main changes of interest relate to the weight given to own company data. Following stakeholder criticism, CEIOPS has increased the credibility weights for internal data so that greater weight can now be placed on an undertaking's own data. A distinction has been introduced between Third-party liability, Motor vehicle liability and Credit & suretyship (for which 15 years' own data is still required for full credibility) and other lines of business (for which only 10 years' own data is now required for full credibility). Where external data is used, the credibility weights are unchanged for Third-party liability, Motor vehicle liability and Credit & suretyship but for other classes the term for maximum credibility has again been reduced to 10 years. It has been clarified that the external credibility weights are to be used in cases where the parameters are based on a mixture of internal and external data. In addition, where historical data is not available on an accident year basis, undertakings are now permitted to carry out the USP calculations using underwriting year data (provided that it can be shown that this gives an adequate representation of accident year basis calculations). Under the scope of former CP71 (non-life underwriting risk), CEIOPS is still considering whether any adjustment is necessary to allow for the risk margin component of technical provisions. The advice is expected to be finalised by the end of March 2010.
   
• Simplifications for technical provisions - CEIOPS does not propose an exhaustive list of simplified methods and techniques for the best estimate, as a principles-based approach is preferred for the Level 2 advice with Level 3 guidance to follow. For the risk margin simplifications, however, CEIOPS believes that Level 2 guidance is necessary due to the complexity and uncertainty of the calculations. The hierarchy of simplifications has been maintained for the final advice, although CEIOPS supports alternative simplifications where undertakings can demonstrate these are appropriate. The 5th level simplification (risk margin as a percentage of the best estimate) is now fully acknowledged as a simplification (for the draft advice this "extreme" simplification was merely considered as a possibility). Also in relation to the risk margin, there has been a change to the situations for which a full calculation of future SCRs is required. Previously, undertakings that were able to carry out the full projection of future SCRs were expected to do so. The final advice requires a full projection of future SCRs where this is needed to capture the undertaking's risk profile. This shifts the focus away from a "best efforts" basis and puts more pressure on undertakings with unusual or complex risk profiles to perform the full calculations, which may be challenging within some existing modelling infrastructures. Following stakeholder feedback, CEIOPS has now provided advice on simplifications for reinsurance recoverables. Reinsurance recoverables may be calculated as the difference between gross and net technical provisions, provided an adjustment has been made for expected counterparty default, and should not include a risk margin. To calculate net technical provisions, gross-to-net techniques will be permitted subject to proportionality criteria provided this is carried out at a sufficiently granular level. 
   
• Simplifications for the SCR - the main changes made to the advice in this area were modifications to the specific simplifications suggested in the draft advice. For example, for credit risk, the suggested simplification in CP77 remains but the criteria for average credit rating for long duration bonds being not less than one rating below the credit rating for short duration bonds has been excluded. "Maturity" bucketing has also been replaced with "duration" bucketing in line with the change to the market risk module. For health revision risk, it was foreseen in CP77 that there would be an adaptation of the life calibrations to reflect the inclusion of inflation and an enlargement of the scope to all kinds of benefits. This has now been dropped and the simplification is identical to the corresponding life module. For non-life catastrophe risk, CEIOPS has still not given advice on the standardised scenarios and this will be addressed at a later stage. All simplifications that used the technical provisions as an input now use the best estimate instead. The advice still does not include any interest rate risk simplifications and therefore all companies, including the smaller ones will be required to discount liabilities using the full yield curve. Some clarification has now been given that quantification of the degree of model error is not required in precise quantitative terms which should help to reduce the burden on firms. 
   
• Simplifications for captives - the requirement that the captive's obligations should only relate to contracts where all insured persons and beneficiaries ("Option 2") are legal entities of the group of the captive at the time the contract was entered into has been retained. Some additional clarification of the terms 'insured person' and 'beneficiary' has been provided. The previous requirement that the captive's insurance and reinsurance obligations do not relate to compulsory third party liability insurance has been modified for the final advice: the requirement now relates only to insurance obligations, but these obligations must not relate to any third party liability insurance rather than just compulsory third party liability insurance. The concentration risk exemption has been kept, although the EUR3m exemption for term deposits has been removed to ensure a level playing field between small and medium-sized captives.
   
• Supervision of group solvency for groups with centralised risk management (CRM) - the changes made to the advice in this area were mainly points of clarification (to address the concerns expressed by stakeholders during the consultation process) as opposed to significant changes in advice. For example, CEIOPS has clarified that CRM only applies to groups with the ultimate parent undertaking located in the EEA, and to EEA subsidiaries of those EEA groups. 
   
• Partial internal models (PIM) - once again the changes made were mainly points of clarification as opposed to significant changes. The non-exhaustive list of what may be considered a major business unit has been extended to include geographical regions. Clarification has been given that for group internal models the definition of what constitutes a major business unit may be applied at group or solo level to avoid a PIM for a major business unit at solo level not being allowed at group level. The list of plausible reasons for excluding particular legal entities from the scope of a group internal model has been extended to include the possibility that the standard formula adequately captures the risk profile of the legal entities and the risk profile of the group is adequately captured. CEIOPS has undertaken to review the list of integration techniques annually (rather than from time to time) and have indicated that a transition period will apply for companies using a technique that is no longer on the list. In determining the period consideration will be given to the available resources, the consequences of the continued use on the reflection of the undertakings risk profile and the proportionality principle. Industry will be somewhat disappointed that, despite strong support for Option 3 for PIM integration with the standard formula (the insurer's chosen method is considered first), CEIOPS has continued to recommend Option 2 (a list of integration methods specified in Level 3 guidance is considered first). It will be important to provide feedback when CEIOPS consults on the Level 3 list of integration approaches to ensure that most methods that insurers would select are included within the final Level 3 guidance.

Next steps

CEIOPS' final advice in respect of the health, non-life and MCR calibrations is expected at the end of March 2010, along with the draft technical specifications for QIS5. CEIOPS will also begin drafting and consulting on the relevant Level 3 guidance.

The European Commission will continue to draw up draft Level 2 Implementing Measures based largely on CEIOPS' advice and discuss these drafts with the Solvency Expert Group.

Further information

The full text of CEIOPS' final advice and the accompanying Feedback Statement is available on CEIOPS' website.