21 October 2013

Danielsson, Koijen, Laeven & Perotti: Solvency II - Three principles to respect

Three concerns

The first concern is disclosure.

It can make sense to grant time to insurers to adjust reserves in the present environment of ultra-low interest rates. Unlike from banks, insurers’ liabilities can be of a very long-term nature. This provides more time to recover and thus justifies a more lenient treatment; see Laeven (2012) for the full rationale.

The proposed legislation, however, is expected to define a precise formula to compute the spread to be added to the riskless discount rate. It will embed forbearance in all stages of the financial cycle by design, while requiring no extra prudential reserve building in good times.

At a minimum, the degree of temporary forbearance (the difference between required capital under fair market value and under adjusted liabilities) should be disclosed and tracked for prudential purposes.

The second concern is prudential intervention.

As the Solvency II legislation will directly set capital requirements with embedded forbearance, the national prudential authorities should be empowered to intervene, certainly if the timing of the review is set as late as four or five years. The departure from fair value implied by the discounting rule chosen needs to be monitored, to ensure it is commensurate to future circumstances and not undermining solvency.

Earlier proposals already introduced discretion in bad times, allowing prudential authorities to extend the time horizon over which required reserves may be restored. However, they did not allow in general prudential adjustments to capital buffers in favourable times, when rates rise and risk premia fall and the automatic discounting increases the reported reserves from a fair value measure. It is quite dangerous for regulators to commit in advance to forbearance in hard times, without any powers to correct rules at times when profits may be overstated in good times or understated in bad times.

The third is timely review.

The Solvency II proposal that may be approved this week will directly become law in all EU countries. All national prudential regulators, such as the Bank of England for the UK, ACPR in France and BaFin in Germany, will be bound to enforce a very novel, embedded-forbearance rule without any chance to adjust it until the proposals are reviewed.

Conclusion

At the critical junction of the closure of Solvency II, the authors identify three simple prudential principles that should be respected.

First, since the rules will create a partially justifiable but opaque departure from fair value accounting, they must ensure disclosure of this adjustment.

Second, the European Commission and the European Insurance and Occupational Pensions Authority should commit to a broad review within three years.

Third, regulatory authorities should retain some discretion to intervene, if prudential concerns arise with the automatic forbearance rule.

Full article

The warnings raised by the academics echo comments made by Gabriel Bernardino, Chair of EIOPA. Speaking at the ECON committee on 30 September, he expressed “concern” about unofficial reports of some of the calibrations to the proposed LTG package. “We need to have a review clause to look at these measures, how they are implemented [and] how consistently they are implemented", he told MEPs. He also stressed the importance of allowing EIOPA to conduct an independent report on the impact of the measures after implementation.

Mr Bernardino reiterated the need for transparency in the use of the measures, as proposed in EIOPA’s LTGA report: “The degree of transparency of this regime needs to be preserved", he said.

Full speech

Further reporting © Solvency II Wire

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