Introduction

The European Commission issued on March 8^th new amendments to the Solvency 2 regulation (2015/35). These amendments will be under review by the European Parliament until June.

“On 8 March the Commission adopted the Solvency II delegated regulation to help insurers invest in equity and private debt by reducing their capital requirements for investments. The regulation, which amends the Solvency II directive, is set to boost private sector investment, a key objective of the Capital Markets Union Action Plan. The amendments will now by subject to three months of scrutiny by the European Parliament and the Council.”

Source :

https://ec.europa.eu/info/business-economy-euro/banking-and-finance/insurance-and-pensions/risk-management-and-supervision-insurance-companies-solvency-2_en

The full text of amendments is here.

 

Main topics (our analysis is limited to market & counterparty SCR):

• Long-term equity investments
• Qualifying unlisted equity portfolio
• Internal ratings
• RGLA (regional government and local authority bonds & loans)
• Insurance & reinsurance companies in the concentration sub-module
• Derivatives in the counterparty risk-module
• Risk-mitigation techniques

 

[The following details are a summary only, and all changes may not be reflected as we focused on the main impacts]

 

Long-term equity investments (article 171a)

Long term equity investments, under specific conditions, will have a lower SCR in this new version.  

This is the most discussed topic in this new version of Solvency 2, and the one that has changed the most since the December 2018 initial draft provided by the European Commission.

Principles

A long-term equity investment will have a 22% shock instead of 39% or 49% +/- dampener.

Criteria

Last version (8 March 2019)	Previous version (December 2018)
Sub-set and the holding period of each investment perfectly identified	Sub-set and the holding period of each investment perfectly identified
Cover the Best Estimates (BE) of one or several identified businesses – and no changes allowed
Managed separately (assets & liabilities)
Only a part of the total business
Average holding period of more than 5 years, if less then no sell allowed till the average period is below 5 year	Average holdings period higher than the liabilities average duration, and more than 12 years
Listed or unlisted equities, having their head offices in EEA countries	Listed or unlisted equities, having their head offices in EEA countries
Ability to hold the position of each individual equity for at least 10 years	Ability to hold the investments – ongoing and stressed conditions – more than 12 years, to be demonstrated to the regulator
All processes (risk management, ALM & investment policies) includes the 5 and 10 years periods above	ALM & investment policies include the intention to hold the investments for a long period

 

Summary of changes for long-term investments (vs December 2018 version) :

• Holding period going from 12 to 5 years
• No more comparison with the liabilities duration
• No more stressed conditions to compute
• Requirement of ability to hold the position for 10 years

[Comments by the French Finance and Economy Minister  : here ]

 

Qualifying unlisted equity portfolios (article 168a)

A lower equity SCR may be applied to unlisted equities (type 1 instead of type 2) in this new version.

Insurance companies are now allowed to consider as type 1 equities (e.g. shock of 39% +/- dampener) any portfolio respecting the following criteria:

• Ordinary shares only
• Not listed in any regulated market
• Head office in an EEA country
• More than 50% of the annual revenues in currencies of EEA or OECD
• More than 50% of the staff located in EEA countries
• At least one of the following:
  • Annual turnover greater than 10 000 000 EUR
  • Balance sheet greater than 10 000 000 EUR
  • Number of staff employed greater than 50
• No more than 10% of the portfolio in each company
• None in the financial sector (including insurance) – e.g. no “K” NACE codes
• Beta of the set of investments less than 0.796 (and the beta formula is fully defined in the regulation).

 

Internal ratings (articles 176a, 176b & 176c)

The use of internal ratings will be allowed in some cases in the new version.

176a – assessment

This part lists criteria that allow to assess a CQS 2 or a CQS 3, depending of the subset of criteria that are met. The list includes the own internal rating defined by the insurance companies.

176b – requirements on assessments

This part lists criteria when assessing an internal rating for a bond or loan.

Article 176c  – assessments based on an approved internal model

Maybe the more interesting part, or anyway an area to explore.

Insurance companies are now allowed to use “someone else” internal rating model – which has to have been approved by a regulator – when co-investing jointly in an unrated bond or loan.

The co-investor could be of any type, and has only to run an approved internal model.

 

RGLA – Spread risk (article 180)

RGLA (regional government and local authority bonds & loans) included in the 2015/2011 Regulation will be treated as EEA government instruments.

So far, RGLA had to be considered as:

• Government bonds, when found in the 2015/2011 Regulation
• Corporate bonds in any other cases

And bonds guaranteed by a 2015/2011 RGLA had a Spread SCR.

In the new version:

• Bonds guaranteed by a 2015/2011 RGLA do not have Spread SCR
• Non 2015/2011 RGLA are considered as “non EEA state, with a CQS=2” (instead of corporate)
• Bonds guaranteed by a non 2015/2011 RGLA are also considered as “non EEA state, with a 2 CQS” (instead of corporate)

 

Insurance & reinsurance companies in the concentration sub-module (articles 182, 186 & 187)

The overall approach changes but the rationale is still the same, and CQS evolve from integer number into decimal number.

A CQS assignation is based on the Solvency ratio – this CQS could be a decimal number, as it has to be interpolated.

Based on this (decimal) CQS, the risk factor g(i) is affected to the single-name exposure.

• The logic is still the same, define the concentration risk, based on the Solvency ratio, interpolating between the bounds given by the regulator, but this time this is the CQS which is interpolated and not the g(i) factor

In our opinion this is done to give headaches to all Solvency 2 software developers – Pillar 1 or Pillar 3 – who considered the CQS as an integer.

 

Derivatives in the counterparty risk module (articles 189 & 192)

In the counterparty risk module, derivatives will be classified in 4 different types, and CDS will be excluded.

Derivatives were not previously fully classified, and the application to the counterparty risk module was subject to interpretation. As an example, it was considered that futures, as cleared in a regulated CCP, were not included in the module.

Now the definitions are much clearer, and we will have 4 cases of derivatives to be handled.

Note that CCP cleared derivatives will generate a counterparty risk, but 5 times lower than “full OTC” products.

CDS will be excluded from the counterparty risk module (they will be dealt with in the spread module).

 

Risk mitigation techniques (article 209 & followings)

In order to apply netting and lower SCR calculations, conditions to comply with will be easier to respect, in particular for the roll frequency of hedges.

We still have the prorata temporis for less than one year hedging positions without systematic rolls, but have now different criteria to fully consider less than one year hedges.

Maybe the most important is the roll frequency, which went from 3 months to 1 week. Additionally the accepted frequency could even be higher than 1 week in case a market event affecst the solvency position of the insurance company.