Group supervision and solvency vex US and EU regulatory talks

Mar 18, 2013

The following article was posted to the website on March 18, 2013:

Group Supervision and Solvency Vex U.S. and EU Regulatory Talks

By Louie Woodall

The US and Europe are at loggerheads over finding a common regulatory framework for insurers. But as they struggle to come to a resolution the IAIS is looming, with its own approach to global regulation that could undermine them both. Louie Woodall reports.

Europeans and Americans have hardly seen eye-to-eye on regulatory reform. In recent years, a flurry of new initiatives has been proposed on both sides of the Atlantic to tackle the issues of solvency and systemic risk. However, neither jurisdiction has warmed to the ideas of the other. When a delegation from the European Insurance and Occupational Pensions Authority (Eiopa) ventured to the US to discuss the issue of US equivalence with Solvency II with the National Association of Insurance Commissioners (NAIC), they were flatly rebuffed. Subsequently, in February 2012, the European Commission admitted that a “different approach” was needed to determine whether the US’s regime was equivalent.

Since then, pressure has grown on both jurisdictions to find some common ground. After all, the NAIC and Eiopa are not the only parties with an interest in the development of international regulation. European insurers have been warning of the commercial implications of the US not being deemed to be equivalent to Solvency II. At the same time, the International Association of Insurance Supervisors (IAIS), based in Basel, Switzerland, has grand designs for the supervision of global systemically important insurers and internationally active insurance groups (IAIGs). Its plans for a common supervisory framework for international insurance groups (ComFrame) are gaining momentum and could have broad ramifications for insurance regulation.

Fortunately, stakeholders in each jurisdiction realise the dangers of being trapped in a deadlock for perpetuity. In an effort to break it, in January 2012 the EU-US Dialogue Project was launched with the noble aim of “enhancing understanding and cooperation for the benefit of insurance consumers, business opportunity and effective supervision”. Throughout the year, a host of organisations from both sides of the Atlantic – including Eiopa and the NAIC – engaged in a fact-finding mission to discover the key similarities and differences between the supervisory regimes in Europe and the US.

Despite the existing tensions over Solvency II, the discussions appear to be bearing fruit. In December, Eiopa published a report on the process entitled The Way Forward, listing seven areas where the project’s stakeholders believed there was potential for greater harmonisation of the two regimes. These were: professional secrecy and confidentiality; group supervision; solvency and capital requirements; reinsurance and collateral requirements; supervisory reporting and data collection; peer review; and third-party review. Technical committees have been exploring these areas, identifying the parts of each regime upon which future agreements could be built, and those areas that pose barriers to progress. A detailed action plan for taking the project forward will be released in the second quarter of 2013.

According to the reports published by the technical committees, progress has been made in a number of areas, especially with regard to a common approach to internal risk governance as embodied in the Own Risk and Solvency Assessment (Orsa).

However, major hurdles stand in the way of a common agreement on a number of other supervisory practices, which threaten to keep the ideal of a unified approach to regulation a distant pipe dream. It seems the weight of decades of entrenched practice on both sides of the Atlantic is proving hard to shift.

Paul Robotham, London-based chief financial officer at Arch Insurance Europe, which includes a UK-based company and Lloyd’s syndicate and which has a sister company in the US, believes that the rapidly changing regulatory landscape in Europe is something the North American industry does not wish to see replicated on its shores.

“The US regulatory structure is well established, well embedded and well understood. It is prescriptive in some regards, but is also geared towards exposure in the sense that it does have a risk-based capital (RBC) submission,” says Robotham. “But compared to our European regulation, the capital modelling is fairly lightweight and high level. Given the consistency of regulation and the stability over time, the Americans do not wish to see changes.”

But US insurers suggest the barriers to progress are on the European side. Gerald Wilson, Baltimore-based chief risk officer at Transamerica, says: “What is really a hindrance to this process is the definition of ‘solvency’. If you look in terms of North America, solvency is making sure we have the ability to pay our claims when they’re due. That’s the floor – you cannot drop below that. The European system, I think is regulatory overreach. They are putting themselves in the place of the management team [within the firm] and their version of solvency is more related to optimising the risk portfolio. We have said this is a dangerous place for you [the regulator] to be because that is really the role of management.”

Between the stubborn defence of existing regulatory practices in North America, and the overly prescriptive nature of Solvency II in Europe, a real ‘way forward’ may be out of reach. Yet, hope remains if the negotiating parties can reach agreement on three key issues: collateral arrangements; group supervision; and solvency requirements. Consensus on these points could clear the road for a joint regulatory framework and, eventually, a global framework as desired by the IAIS.

On the first issue – collateral arrangements – the NAIC and Eiopa appear at loggerheads. The current system in the US obliges unlicensed reinsurers (those domiciled outside the country) to post collateral in order for the US ceding company to be granted statutory credit, a practice that is banned across Europe. Naturally, EU firms resent the double standard that puts them at a competitive disadvantage in relation to their US peers.

Paul Clarke, global Solvency II leader at PwC in London, explains: “[Collateral requirements] are unpopular with European insurers because it presents an operational constraint around the free flow and fungibility of funds around the group. It particularly has an effect on those companies that are very active in the US market, such as the Lloyd’s insurance market, which has to hold significant assets in the US as security against insurance balances.”

The abolition of these requirements is crucial for Eiopa. “Collateral requirements are not compatible with a level playing field for internationally active insurance groups,” a spokesperson for the authority says.

Yet the Americans do not seem keen to play ball. Collateral is seen as a vital safeguard against credit risk and regulatory risk, and the NAIC is reluctant to abandon them altogether. “There are some risks associated with reinsurance collateral reduction. It is important to note that collateral may continue to be an important part of a ceding insurer’s risk mitigation strategy,” an NAIC spokesman says.

Some European insurers are less anxious about this issue than others. Robotham at Arch Insurance argues that collateral is just the US’s preferred method of managing credit risk and is comparable with Solvency II’s incoming capital charge for reinsurance, so should not be made a deal-breaking issue.

“Reinsurance is the most unregulated product there is for markets in our industry. The US requires collateral because it has no regulatory supervision over the third-party reinsurer. In the European Union [EU], we are taking a capital charge on all those reinsurers that do not have sufficient credit security,” he says.

However, Solvency II’s capital charge and the US collateral requirements are not necessarily identical. Robert Curtis, director of insurance risk at KPMG in London, thinks a common language on credit risk would solve the problem. “If you were on the same rulebook on both sides of the Atlantic, you wouldn’t need collateral requirements. I think the NAIC is saying it is unable to know what foreign reinsurers are doing because it doesn’t have the information, and this creates the mistrust that leads to collateral demands,” says Curtis. He suggests that if the US and Europe converged around one set of international requirements that mistrust would vanish.

The fact that both Eiopa and the NAIC have taken a firm stand on collateral does not mean, however, that there is no room for negotiation. The NAIC has already begun to dismantle barriers to cross-border reinsurance transactions. A package of amendments to the NAIC Credit for Reinsurance Model Law & Regulation passed in 2011 produced a list of ‘qualified jurisdictions’, making reinsurers and insurers domiciled in these countries eligible for collateral reduction.

The association also devolved responsibility for setting collateral requirements to individual state regulators, and established a certification process allowing approved insurers to qualify for a sliding scale of collateral reductions based on a rating system. However, the proposed revisions are an optional standard for US states. Individual supervisors can maintain the 100% collateral requirement on non-US licensed reinsurers and remain accredited.

So far, 11 states have chosen to reduce their collateral provisions, including New York and Florida. This has been welcome news to Lloyd’s of London, the specialist reinsurance market. As a result, Lloyd’s insurers, many of which reinsure US insurers, have been able to post reduced collateral equal to 20% of gross liabilities, compared with 100% previously.

For many in Europe though, this is not good enough. Olav Jones, Brussels-based deputy director-general of trade body Insurance Europe, stated in a letter to the chair of the NAIC reinsurance task force that the organisation “regrets that the consideration of the list of qualified jurisdictions remains optional for the individual states that can maintain the 100% collateral requirement on non-US licensed reinsurers”. Even those reinsurers based in qualified jurisdictions can still be made subject to collateral requirements, in “stark contrast to US domestic reinsurers”, he went on to say.

Yet things are not as clear cut as simply blaming the Americans for dragging their feet. Robotham thinks one of the unintended consequences of Solvency II’s credit risk charge for reinsurers will be a rolling out of collateral requirements between firms within Europe itself. “I can see European cedents who are insurers for captive-fronting programmes demanding collateral whereas previously they might not have asked for it, and the impetus is moving the other way,” he says, especially in transactions with lower rated reinsurers. “It’s not about whether you provide collateral or not, the discussion could take the form of the amount of collateral that is required,” he adds.  

Group supervision

A core objective of the Dialogue Project is to establish a strong regime for group supervision. However, ideas about what makes a ‘strong regime’ are very different in Europe and the US. Eiopa’s report on the progress of the project defines group supervision as something that monitors risk concentrations, considers all entities belonging to the group, is led by a single group supervisor, and is equipped with suitable enforcement measures. While this reflects the European approach to group supervision as embodied in Solvency II, such a framework is alien to US insurers and state regulators.

In the US, supervision of non-insurance entities that form part of a group is not within a state regulator’s mandate, whereas in the EU, all members of the group are subject to scrutiny. Similarly, US law does not demand an explicit group capital requirement, while Solvency II will require a group Solvency Capital Requirement (SCR) to be reported on a regular basis. Reporting requirements also differ across jurisdictions. Only certain large insurers within the US need to submit an Enterprise Risk Report to the regulator, unlike in the EU, where Solvency II requires all firms that come under its jurisdiction to report on solvency at the group level.

These differences make the goal of harmonised group supervision a mammoth task, according to PwC’s Clarke. “The barrier at the moment is the concept of group supervision, which is relatively varied around the world. Culturally, the balance between group supervision and company [legal entity] supervision is very different in the US compared with Europe, where group supervision has been part of the infrastructure and is relatively well established. You are starting from different points, so getting people to converge on a common position can be tricky.”

An accord on group supervision is seen by many as the linchpin of the Dialogue Project’s plan. The logic is if European and US regulators all conform to the same standards and taxonomy, things like group capital requirements and governance standards will follow naturally. What stands in the way of convergence is each jurisdiction’s jealous protection of its own methodology.

Eiopa insists on the establishment of a single or lead group supervisor in any future framework. The NAIC, meanwhile, argues that the focus should be “on the respective jurisdictions establishing a robust regime for group supervision through greater cooperation among supervisory authorities”.

KPMG’s Curtis believes the US is lagging behind the rest of the world when it comes to group supervision. “The US regime is legal-entity based. They [the state regulators] might say they all come together and look at large groups, but the fact is they do not have a group-wide set of requirements, even though the IAIS insurance core principles on group-wide supervision actually requires them to do that,” he says.

However there are signs that the US system is changing. While the statutory power to regulate insurers lies with the individual states, federal institutions are beginning to flex their muscles in response to changing times. The NAIC may not be a federal supervisor, but by encouraging supervisors to implement the Orsa model act, and even to reduce collateral requirements where appropriate, it certainly wields a strong influence.

Another body that could assume the mantle of federal supervisor is the Federal Insurance Office (FIO), the remit of which includes monitoring all aspects of the insurance industry, identifying issues and gaps in current regulation that could lead to a systemic crisis, and developing federal policy on international insurance matters. This mandate would seem to supersede that of the state regulators.

“With the FIO, although it doesn’t necessarily have teeth yet, you have the threat that the Feds will come in, and US-based IAIGs will be supervised by the FIO,” Curtis says.

For the moment the state regulators retain their sovereign powers, though perhaps for not much longer. In spite of the differences between group supervisory frameworks, there are some areas of overlap where mutual agreement looks promising. For example, US insurers seem amenable to the idea of colleges of supervisors as a means of achieving closer supervision. Transamerica’s Wilson says: “Part of group supervision is really making sure the regulators themselves work better together. In North America we’ve come round to the idea of the supervisory college. We think that makes sense, we like the idea of having a lead regulator, coordinating questions, and only having to answer things once to one body.”

The Orsa is another area in which there is potential for agreement. The project seeks to promote harmonisation of Orsa reporting, and create a common template that can be used by both EU and US groups. Eiopa hopes a joined-up Orsa process will avoid the duplication of work for international groups, which currently have separate reporting requirements for their EU and US businesses. The issue is that the Orsa being developed under Solvency II and the Orsa process that is under way in the US are very different beasts.

The primary difference between the two is that the EU Orsa is much more prescriptive than the US version, as the former is codified in the Solvency II Directive, which sets out in precise terms what is expected of firms. The NAIC’s guidance on the Orsa, meanwhile, allows firms discretion to develop a framework that suits the structure of the company. It is a principles-driven process rather than a rules-based one.

Betsy Ward, chief enterprise risk officer at MassMutual, based in Springfield, Massachusetts, describes the collaborative approach by which the US Orsa was developed. “The industry worked with the NAIC to describe and pilot a programme to further share what insurance companies are currently doing to manage risk,” she says. “For example, the North American Chief Risk Officer Council provided some education and participated in discussions on public conference calls throughout the drafting. The NAIC working group stated it expected to be evolutionary in its development of an Orsa.”

Wilson at Transamerica believes this approach is producing an Orsa framework that actively encourages cooperation with the regulator and is preferable to the European process. “If you look at the Solvency II Orsa, it is very prescriptive. [In the US] look at the number of people who participated [in developing the US Orsa]. People want to do it, and in the absence of the specificity [required in the Solvency II Orsa], what you get is a lot of traction being made. Even though there were differences [in submissions], the NAIC said it was really pleased with what it got from it.”

As a result, the US Orsa is seen as being more flexible and firms are happy to be engaged in the process, leading some to suggest that European policy-makers could learn from this experience. While the European version of the Orsa is one of the more popular elements of Solvency II, there are concerns among insurers that the strict requirements written into it may prevent harmonisation in the near term.

Arch’s Robotham strikes a typical note of caution: “As far as the US is concerned their regulation is perfectly sufficient for their requirements, so unless the EU is willing to bend to their basis of regulation there is little chance of harmonisation. The US has no desire to change to a more prescriptive capital modelling basis.”

This view is shared by MassMutual’s Ward, who predicts that if US regulators were to throw out their version of the Orsa in favour of the European model “the industry would protest”.

Still, groups operating on both sides of the Atlantic hold out hope that the two Orsa programmes can be brought into alignment. “We are aware of a number of US and European groups whose ambition is to create a single process that will be able to satisfy both the EU and US requirements out of essentially the same process,” says PwC’s Clarke.

Transamerica is one of these companies, according to Wilson, who says that the most positive outcome of the dialogue project would be a harmonised Orsa applicable to both EU and US jurisdictions. “There’s no insurer out there that wants to have multiple filings. When you think about harmonisation, currently insurers in North America have to do a US filing and, since we have a European parent [Aegon], we also have to provide information to them on a different basis. The closer we can get to one key metric or one key valuation, that is helpful for us.”

Solvency standards

Solvency requirements is arguably the area where the differences between the EU and US approach to regulation seem unbridgeable. In the US, insurers are not regulated on a ‘no-failures’ basis and state supervisors focus their attention on ensuring those that do fail are sufficiently capitalised to run off without event. While the domestic industry is happy with the status quo, the failure of AIG in 2008 found the system wanting.

“The big hole in the no-failures theory was AIG, when its non-traditional insurance products caught everybody by surprise,” Robotham says. “We still haven’t seen a response from US regulators against that sort of practice.”

US insurers do not think the example of AIG is fair, considering the architects of its downfall were not involved in traditional insurance activities. Wilson is a fervent believer in the existing risk-based capital regime, where regulatory minimums are less prescriptive than those outlined in the current drafts of Solvency II. “The regulator shouldn’t be the one dictating the additional steps we are taking [to manage risk],” he says. “Holding more and more capital, setting more and more requirements, doesn’t mean you’ve truly addressed the problem.”

However, KPMG’s Curtis thinks it is institutional inertia tying the US to a regime that, to some in Europe, is outdated. “In the US, when they were going through their RBC reforms in the 1990s, these concepts of confidence levels and time horizons included in Solvency II didn’t exist,” he says.

Far from Solvency II being overly prescriptive with regard to capital charges, Curtis argues that regulators are simply reflecting evolutions in the market. He says that Solvency II’s SCR of  99.5% value-at-risk over one year equates to the minimum capitalisation required for an insurer to be rated BBB by Standard & Poor’s. “The policy-makers argue that if this is where the market is determining where the de minimis capitalisation level is, then why shouldn’t they make it a statutory requirement to use that level?” he asks.

Ultimately, convergence on solvency minimums depends on high-level agreement over group supervision. Until US supervisors demand that firms provide a group capital requirement, cheerleaders for harmonisation will find their hopes frustrated.

For now, there seems to be no interest on the part of the US to see the current RBC metric superseded. MassMutual’s Ward promotes the US insurance industry’s view: “A common benchmark across groups has been an often discussed objective of the regulators at IAIS meetings. I continue to believe it is more important for regulators to understand the risk management of the group and the supervisors’ separate jurisdictional requirements.”

Is the EU-US Dialogue Project doomed to failure? On the key issues, common agreement seems out of policy-makers’ reach for now. However, the quest for harmonisation may soon be taken out of Eiopa’s and the NAIC’s hands. The IAIS is steaming ahead with its proposals for ComFrame, and the hot topic of systemic risk could impose a group supervisory framework on US insurers with or without their consent.

“In the context of the global systemic risk debate, insurance supervisors will soon have to put down some well-defined markers that groups will be required to follow,” says KPMG’s Curtis. “What you end up having is a set of systemic risk requirements that come in over the top [of domestic regulations] for regulating the big American groups like MetLife, AIG and Prudential Financial. When that happens, the state-based system breaks down because the largest groups have separate requirements that will have to be monitored by a federal regulator,” he adds.

So all the current wrangling between European and US stakeholders may be academic as the world slouches towards a global framework anyway, impelled by the need to eliminate systemic risk. “By hook or by crook, it’s going to get there,” says Curtis.

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