Solvency II Review: European Commission shows its hand

While the work carried out to date by European Insurance and Occupational Pensions Authority (EIOPA) has focused on the technical side of the Solvency 2 review, the launch of the European Commission’s consultation and roadmap for the Solvency 2 review provides insights into the political priorities that will shape the outcome of the review.

While the request for advice to EIOPA was a long laundry list of 19 different issues for consideration, the European Commission’s work is focused on five broad themes:

• enhancing the ability of the insurance industry to finance the economy, in particular the economic recovery from Covid-19, by mitigating the impact of short-term market volatility on the solvency position of insurers and facilitating the provision of long-term guaranteed products while taking into account the low interest rate environment;
• improving the proportionality of the framework to reduce the regulatory burden on smaller firms;
• strengthening the internal market for insurance by improving supervisory convergence and enhancing policyholder protection;
• preventing the build-up of systemic risks and ensuring financial stability; and,
• ensuring that the framework provides incentives to address sustainability, in particular climate change, in insurers’ investment and underwriting activities.

The use of market-sensitive measures to set capital requirements is seen as being at odds with the long-term investment horizon of insurers and has long been an area of contention between the industry and regulators.

While numerous tweaks have been introduced since Solvency II first came into force to reduce the risk charge for certain targeted long-term investments, including for infrastructure, private debt and long-term equity, this has not addressed the root cause in a holistic way and has only made the framework more complex.

The case for ensuring that insurers can provide long-term financing to the economy has never been stronger, given the urgent need to finance the economic recovery from Covid-19. In its report on furthering the Capital Markets Union, published in June, the High-Level Forum established by the European Commission also called for changes to Solvency 2 to facilitate insurers investing in equity, securitisation and the provision of financing to SMEs through private debt markets.

However, there is a countervailing wind coming from EIOPA. In its work, it has also been exploring whether certain provisions, such as the volatility adjustment and the calibration of long-term interest rates, have in fact led to the underestimation of risk.

The European Commission, therefore, will need to weigh the relative merits of introducing limited or more comprehensive changes to the framework. In the case of the latter, the European Commission has underscored that it should not lead to a significant deterioration in the average solvency position of insurers, which would hinder their contribution to financing the recovery.

The role of the insurance industry in supporting the EU Green Deal will also be a live debate within the Solvency 2 review. Measures to ensure that sustainability risks are taken into account by insurance under Pillar 2, in particular as part of the prudent person principle and in risk management, were already underway and the final draft rules were put out for consultation earlier in June.

In this consultation, the European Commission is looking to go even further and is requesting feedback on whether climate and sustainability should also be integrated under Pillar 1. This would be either in the form of a “green supporting factor”, which would lower capital requirements for green investments, or through a “brown penalising factor”, which would add a capital surcharge for unsustainable activities. It is clear from the roadmap that the European Commission favour the former, which could be tied to the newly adopted EU Taxonomy.

The consultation also explores the introduction of climate scenario analysis, which has already garnered significant momentum across the regulatory community and the industry. The Network for Greening the Financial System, as well as a number of national regulators, are already testing approaches for climate scenario analysis. It is, therefore, more a matter of when, rather than if, this becomes a core part of the Solvency 2 framework.

Another area likely to elicit strong views relates to financial stability and ensuring a level playing field across Europe. While the insurance sector has borne up well during the current crisis, regulators, including the European Systemic Risk Board (ESRB), continue to press for more tools to ensure financial stability, including more macroprudential tools.

The European Commission is seeking views on whether any changes should be limited and targeted or whether there is a need to introduce significant new tools to manage financial stability risks as suggested by the ESRB.

The European Commission’s consultation also explores options to strengthen the regime for cross-border supervision, introduce an EU recovery and resolution regime, and harmonise insurance guarantee schemes.

The inception impact assessment is subject to consultation until 26 August, while the more detailed stakeholder consultation is open until 21 October. 

First published in Insurance Asset Risk.