The EU’s Solvency II proposal: Key take-aways and what’s next

At a glance:

• The proposal of the European Commission (EC) sets out its proposed changes to the Solvency II framework. It follows EIOPA’s recommendations closely, although certain aspects, including reforms in relation to the risk margin, will be addressed at a later stage in more detailed delegated legislation.
• The package of reforms strengthens supervisory powers across a range of different areas, most notably in relation to recovery and resolution and insurers’ financial condition, including for the latter the ability to restrict dividends in certain situations.
• By mandating EIOPA to explore a dedicated prudential treatment of exposures associated with environmental and/or social objectives by 2023, the EC postpones any consideration in relation to introducing specific sustainability-related capital incentives. The proposal does, however, include a new requirement for insurers to conduct climate scenario analysis.
• We expect the amendments to the Directive itself to come into force in 2023/2024 based on the legislative process following the publication of the EC’s proposal. However, it will be a further 18 months before they are transposed and apply for practical purposes in individual member states, with transitional measures also applying for some of the changes. Insurers should spend time understanding the scope of the proposed changes and their implementation strategy, and monitor developments in relation to more detailed Level 2 and 3 regulations.
• The proposals do not, of course, apply to Solvency II as implemented in the UK, which is subject to a separate UK-specific review. Divergence between the EU and UK approach to Solvency II appears to be inevitable and firms operating in both jurisdictions should consider how this affects their strategy and operations.

Introduction

Yesterday, the EC published its proposal for the review of the Solvency II Directive. The proposal largely builds on EIOPA’s Opinion on Solvency II. It also clarifies that certain elements will be addressed in separate Level 2 measures.

Broadly, the EC’s proposal is centred around enabling insurers to contribute to the sustainable long-term financing of the economy and post COVID-19 economic recovery, as well as supporting EU’s objective to ensure a level playing field in the insurance market. As expected, the proposal suggests greater codification of rules across multiple areas of Solvency II (in stark contrast to the direction of travel in the UK - see earlier blogs here and here) and consistency of insurance supervision across the EU. It also generally increases the range of supervisory powers and tools available to EU supervisors in a number of key areas, including in relation to recovery and resolution, group supervision and liquidity risk management.

This blog analyses the most important aspects of the EU’s Solvency II proposal, and the potential impact these would have for insurers. It also discusses some important items that are not covered by the EC’s proposal, and what the EU’s next steps are in terms of timelines and implementation.

The proposals do not, of course, affect Solvency II as implemented in the UK, which is subject to its own UK-specific review. As noted above, the general direction of the EU proposals towards increased detail in rules and codification of supervisory judgment stands in contrast to the UK review, which, in general, seeks to reduce codification and increase the reliance on judgments made by supervisors. However, the reviews also share many common objectives around, for example, the role of the insurance sector as investors in the real economy and the implementation of sustainability objectives. There are, therefore, areas of both overlap and difference between the parts of Solvency II being reformed. Divergence between Solvency II in the UK and EU now appears a certainty. It is therefore critical for insurers operating across both markets to understand these changes and how they will affect their operations, processes, supervisory interactions and governance.

What are the main areas of change EU’s proposal?

Proportionality: The proposal introduces the new concept of “low-risk undertakings”. These undertakings should be able to apply simplifications including more proportionate regulatory reporting requirements and a simplified calculation of Standard Formula (SF) SCR. These measures would also be available to insurers above the “low-risk” thresholds where approved by the relevant supervisor. These measures should ease the regulatory burden for small firms and provide more clarity and consistency on how proportionality may be applied. However, insurers that apply proportional measures other than those codified in the proposed requirements may need to explore, in discussion with their supervisors, whether changes in approach will be required.

Reporting: The EC proposes a number of changes to rules around reporting, including more proportionate reporting requirements for “low-risk undertakings”, a modified structure of the Solvency and Financial Condition Report (SFCR), and the introduction of a new audit requirement for insurers’ prudential balance sheet, group balance sheet and/or single SFCR. Insurers will need to align their internal policies and processes with these new requirements both in terms of format and timelines.

Long-term guarantee measures: The proposal includes a series of amendments to the long-term guarantee measures that will be complemented with more detailed Level 2 delegated acts. The EC proposes changes to the Volatility Adjustment (VA) that include a higher percentage of the risk-adjusted spread to be taken into account in the VA, an undertaking-specific “credit spread sensitivity ratio”, and replacement of the country component of the VA with a macro VA for Member States whose currency is the euro. Use of the VA will also require supervisory approval going forward, and the EC also proposes “safeguards” where insurers use the dynamic VA.

On risk free rates, the EC proposes a new extrapolation method for risk free interest rate term structures that takes into account information from financial markets. This is proposed to be phased in linearly over a period running until 2032, during which insurers will have to disclose the impact of the new extrapolation method without the phasing in. The EC also indicates that it will carry out further work on extrapolation through the delegated acts, building on EIOPA’s proposals in its Opinion.

Macro-prudential tools: The EC suggests a new macro-prudential toolkit that would strengthen supervisory powers significantly. This includes, for example, powers that enable supervisors to, during exceptional situations, impose temporary freezes on redemption options on life insurance policies, and to suspend or restrict dividends. The new rules also introduce requirements on liquidity management; notably, insurers will have to develop liquidity risk indicators. These various measures signal a renewed supervisory focus on macroprudential and liquidity risks in the insurance sector, likely fuelled in part by economic upheaval caused by the pandemic.

Recovery and resolution: The Solvency II proposal was accompanied by another proposal in relation to an EU-wide recovery a resolution framework. The proposed framework would be more akin to a banking-style resolution framework, with member states setting up insurance resolution authorities that have a number of resolution powers and tools at their disposal (including e.g. write-down or conversion of capital instruments, solvent run-off and bridge undertaking). This is a significant development for the EU insurance sector overall and is likely to require significant work by both insurers and supervisors.

European Green Deal: The EC proposes several amendments related to the European Green Deal, including a new requirement for insurers to identify material climate risks and assess the impact of at least two long-term climate scenarios on their business. This may be a significant exercise for insurers that have not conducted internal climate stress testing before. The EC notes that it may also consider extending this requirement to other environmental risks, raising the potential for further future work to be required in areas such as, for example, biodiversity.

The EC also mandates EIOPA to explore by 2023 a dedicated prudential treatment of exposures related to assets or activities associated with environmental and/or social objectives. This has the effect of postponing further any decision in relation to introducing formal quantitative climate considerations into the Solvency II capital framework. However, for firms this will likely mean further climate-related information and data requests from EIOPA in 2022.

Group supervision: The EC introduces several clarifications and amendments to existing rules that will codify how groups are supervised – currently the area of Solvency II that is arguably most reliant on supervisory judgment. This includes, for example, clarifications around the classification of groups, calculation of group capital requirements and supervision of intra-group transactions. It also provides for supervisors to impose requirements directly at the level of holding companies, and new supervisory enforcement powers including, as a last resort measure, the power to require groups to adjust their structure. Insurance groups should review these new proposals in detail to understand to what extent they are affected by the new rules or have to do anything differently as a result. The proposals may, for example, affect the calculation methodology for the Group SCR, supervisory requirements at non-EEA holding company levels, or indeed the regulatory classification of the group altogether.

What has not (yet) been covered?

There are a few important areas that are not covered in the EC’s proposed changes to the Solvency II Directive. The most obvious and important of these is reform in relation to the calculation of the risk margin. The EC indicates that it will consider building on the Lambda approach proposed by EIOPA in its Opinion, but without a floor parameter to allow for more effective mitigation of volatility than under EIOPA’s proposal. It will also consider reducing the cost-of-capital rate used in the risk margin calculation from 6% to 5%. Together, the EC suggests that these changes would reduce the size of the risk margin by more than €50 billion across the EU insurance sector.

Some of the other areas that the EC will explore through delegated acts include, for example:

• revisiting eligibility criteria for the long-term equity asset class and simplifying the conditions under which equity investments, including infrastructure funds, would be treated as “long-term”;
• introducing an undertaking-specific element in the VA in the delegated acts in order to avoid overshooting of the VA;
• exploring further the rules on diversification benefits and asset eligibility criteria for the matching adjustment (MA), as well as introducing a safeguard to avoid “excessive relief” where MA portfolios include restructured assets;
• revising the standard formula calculation for interest rate risk, building on EIOPA’s proposals

Lastly, the EC clarifies that, given economic uncertainty and the need to focus on economic recovery, action to align rules for insurance guarantee schemes is not appropriate at this point in time.

In addition, we would also expect EIOPA to review, update and augment its Guidelines as a result of the review.

What are the next steps?

Yesterday’s proposal from the EC set out its changes to the Solvency II framework at the level of the Solvency II Directive itself. This is a hugely important step in the Solvency II review process, but nonetheless only one step in what is still a relatively long process.

The proposed Directive will now be subject to review by various stakeholders and, once agreed, will enter into force on the twentieth day following that of its publication in the Official Journal of the European Union. We expect this to be in 2023/2024. It will then be a further 18 months before they are transposed and apply for practical purposes in individual member states, with transitional measures also applying for some of the changes.

We also expect to see the EC and EIOPA work together to develop some of the more detailed aspects of reform, particularly through supporting delegated acts and supervisory guidance. However, the EC does note that it will not introduce any changes to delegated act at this stage, but rather wait for the finalisation of the legislative process before enacting any necessary changes to ensure a consistent delivery of the review of the Solvency II framework. The full review outcomes may, therefore, still take some time to emerge.

In preparation for implementation, insurers should spend time understanding the scope of changes and how these will apply to them and develop a strategy for implementation, while monitoring and taking account of developments in relation to supporting regulations and guidance.

The package of reforms strengthens supervisory powers across a range of different areas, most notably in relation to recovery and resolution and insurers’ financial condition, including for the latter the ability to restrict dividends in certain situations.