In 2023, EIOPA has published several recommandations and progress reports, the most insightful being:
Advice to the European Commission on Greenwashing – EIOPA-BoS-23/157 – 01 June 2023
Consultation Paper on the Opinion on sustainability claims and greenwashing in the insurance and pensions sectors – EIOPA-BoS-23/450 – 17 November 2023
Both documents contain highly important information and guidelines towards a future framework for the industry, a framework probably to be applicable no later than 2025.
As outlined in both papers, EIOPA addresses these guidelines in close cooperation with the two other ESA in charge of financial services supervision, EBA and ESMA. It’s advice summarizes this interconnectedness with a « Sustainable Finance Investment Value Chain » chart:
The Advice to the EC defines the meaning of « Sustainibility Claims« , the critical item to be addressed to analyse any kind of greenwashing activity within this value chain.
‘Sustainability claims’ are claims that state or imply that an entity or product ‘benefits’ the environment or society. The type of ‘benefit’ is varied and includes:
positively impacting sustainability factors;
not impacting sustainability factors;
minimizing negative impacts on sustainability factors;
minimizing the impact of climate change on society (this includes climate adaptation measures).
This understanding of ‘sustainability claims’ is consistent with the definition of “environmental claims” as defined in the EC proposed Directive as regards empowering consumers for the green transition which would amend the Unfair Commercial Practices Directive (UCPD): “‘environmental claim’ means any message or representation […], which states or implies that a product or trader has a positive or no impact on the environment or is less damaging to the environment than other products or traders, respectively, or has improved their impact over time”. ‘Sustainability claims’ as understood by EIOPA extends it to also cover social aspects.
Misleading sustainability claims can deceive consumers into buying products that are not aligned with their preferences, or into buying products from a pension or insurance provider that misleadingly portrays itself an entity with sustainability credentials. In such cases, consumers’ investments or premiums are re-routed away from sustainability factors.
Further, greenwashing occurrences erode consumers’ trust in providers’ ability to positively impact environmental or social factors. While EIOPA has not identified to date any major greenwashing cases in the insurance and pension sectors, because cases emerged in other sectors there may be already a general mistrust from consumers in relation to sustainability claims which can be made by providers. The EU-wide Eurobarometer survey carried out by EIOPA in June 2022 shows that 62% of EU consumers do not trust the sustainability claims made by insurance undertakings or distributors, while a similar percentage (63%) says that sustainability claims about insurance products are often misleading. Consumer representatives in their response to the ESA Joint CfE in January 2023 also reported limited trust in insurers and pension providers sustainability claims.
Additionally, misleading sustainability claims do not allow consumers as well as broader society to hold providers accountable for their environmental and social impact. This unaccountability might embolden providers to make misleading sustainability claims to gain a competitive advantage over other providers, after which these other providers might follow suit to close the competitive advantage, leading to more greenwashing occurrences.
Where and How Greenwashing Occurs in the Insurance and Pension Sectors
EIOPA differentiates seven major fields (three specific stages for insurers, three for IORPs and one common stage for both types of organizations) within the insurance and pensions lifecycle chart:
The major difference among insurers and IORPs are the reference to « products » and « schemes », taking into account the still highly heterogenous pension market and pension scheme providers within the EU.
In relation to the stages of the insurance and pensions lifecycle, respondents to the ESA Joint CfE provided views on the likelihood of the occurrence of greenwashing:
Declared likelihood shows that Marketing and Sales a clearly fingerpointed as they are considered « highly likely » to be subject to greenwashing. Without neglecting the other stages and especially the entity model and management clearly in the drivers’ seat of the other stages’ behaviour, let’s focus on the product delivery issues:
Marketing: main fields of potential greenwashing have their origins in the risks related to terminology and non-textual imagery.
Sales: information asymmetry or misleading information/disclosure as well as risks related to unsuitable product due to poor advice, incentives and distributors’ training are cited as potentially important and critical
Tackling Greenwashing
EIOPA regularly conducts surveys with the NCA to evaluate maturity and action plans as long as the framework is not in place.
Results are for the time being relatively mitigated as the large majority of NCA (21) didn’t identify greenwashing issues yet due to missing criteria to be applied and inexisting client related investigations. However, NCA reporting first actions are using several techniques EIOPA will probably evaluate and adopt for the future framework:
Very interesting also the survey results on the potential use of Suptech to deal with the enormous need to analyze data on products, sales and marketing practices:
Next Steps
Based on additional analyses, discussions and evidence that emerges by the delivery of the final report (May 2024), EIOPA will further refine its view on the definition of greenwashing, its impacts and risks (particularly on potential financial stability risk implications), as well as on how greenwashing can occur in the insurance and pensions lifecycle. To further exemplify the latter, EIOPA might develop case studies showing how greenwashing can emerge in practice.
EIOPA will also provide further considerations on the supervision of greenwashing, particularly in relation to any new greenwashing-related supervisory experiences and practices, as well as in relation to greenwashing-related supervisory and enforcement measures, if any.
Finally, EIOPA will further develop the list of issues it has already identified in the regulatory framework and based on those issues it will propose improvements – by way of recommendations – to the regulatory framework relevant to the insurance and pension sectors, including to Level 1 legislation. However as requested by the CfA, EIOPA will not make any proposals that would imply modifications of the Corporate Sustainability Reporting Directive (CSRD).
December 13, 2023, EIOPA has published a Consultation Paper regarding potential amendments of the prudential treatment of sustainibility risks (EIOPA-BoS-23-460). The expected Article 304a of the Solvency II Directive mandates EIOPA to assess the potential for a dedicated prudential treatment of assets or activities associated substantially with environmental or social objectives, or harm to such objectives, and to assess the impact of proposed amendments on insurance and reinsurance undertakings in the European Union. EIOPA is required to submit a corresponding report to the Commission.
A discussion paper outlining the scope, methodologies, and data sources for the analysis has been published in 2022 as the first outcome of EIOPA’s work under this mandate. This consultation paper is the second outcome, based on the discussion paper’s public feedback received, together with the feedback received from the Platform on Sustainable Finance and the European Banking Authority (EBA). It will form the basis of the report envisaged to be submitted to the Commission after consulting the European Systemic Risk Board (ESRB).
EIOPA decided to focus its analyses on the following three conceptual areas that are considered to be appropriate for a risk-based analysis:
The first area of the analysis is dedicated to the potential link between prudential market risks in terms of equity, spread and property risk and transition risks.
The second area of the analysis focuses on the potential link between non-life underwriting risks and climate-related risk prevention measures, since the prudential treatment of assets or activities as referred to in the mandate includes insurance undertakings’ underwriting activities.
The third area of the analysis is related to the potential link between social risks and prudential risks, including market and underwriting risks.
As a kind of « disclaimer » EIOPA states that « since sustainable finance is an area characterized by an ongoing progress regarding data availability and risk modelling, certain natural limitations of the analysis exist at this stage« :
Firstly, the sample size of certain asset portfolios for the analysis is relatively small due to general data constraints that can hardly be overcome. Further to this, the limited sample size covered in the present analysis might not reflect the overall insurers’ exposure to transition risks, which could also materialize from indirectly held assets.
Secondly, since legally binding transition plans of firms, for instance in relation to the Corporate Sustainability Reporting Directive (CSRD), are not yet available, reliable firm-specific characteristics affecting the (long-term) transition risk exposures of firms are difficult to obtain as further input data for the analysis. In this respect, a sectoral classification approach is generally not able to model firm-specific transition risk characteristics, which would require a firm-level approach instead.
Thirdly, technical challenges for the analysis exist in isolating transition risks from other risk drivers, such as the impact of the Covid-19 shock on asset prices, which is an important determinant for the backward-looking analysis, but not for the forward-looking analysis.
Fourthly, the exact extent to which credit ratings reflect transition risks remains unclear at this stage, making it challenging in the case of the prudential treatment of spread risk in the Standard Formula whether a dedicated treatment would be justified.
By acknowledging the methodological limitations in the context of assessing sustainability risks from a prudential perspective, EIOPA, at this stage, does not recommend policy options in all areas studied in this consultation paper, and does not express a preference between the options proposed as regards equity and spread risk in relation to transition risk exposures.
Potential link between prudential market risks in terms of equity, spread and property risk and transition risks
The challenging question arises as to whether to rely on historic asset price data to conduct an empirical risk analysis (backward-looking) or to use model-based risk assessments, typically in terms of stress scenarios (forward-looking), or a combination of both.
The feedback EIOPA received to its 2022 discussion paper (« Discussion paper on physical climate change risks ») overall support for the methodologies outlined regarding the forward-looking analysis. Some respondents mentioned that the use of a model-based assessment can be subject to technical bias due to the model assumptions taken, and corresponding findings should be treated with caution regarding the conclusion on potential prudential implications. Several respondents suggested focussing only on a forward-looking assessment, since historic time series data might not be able to show a potential materialization of transition risks.
EIOPA considers forward-looking model-based risk assessments to offer valuable insights into the potential impact of transition risks on asset prices, particularly since historical asset price data may not fully reflect the dynamic nature of environmental externalities and the complexities of transitioning to a low-carbon economy. Market sentiment, technological advancements, regulatory changes, and societal awareness of climate issues can significantly influence transition risks in the future. A comprehensive model-based approach can complement historical data analysis and provide a holistic view of how transition risks may materialize in asset prices.
A forward-looking assessment requires models and assumptions regarding the future developments of climate change and the transition to a carbon neutral economy. In particular, uncertainty surrounds the nature and timing of policy actions, technological change and the extent to which financial markets are already reflecting a transition scenario in asset prices. In other words, the results and conclusions obtained can be quite sensitive to the choices adopted for such parameters and assumptions. To capture such uncertainty, researchers make use of scenario analysis to analyse a broad range of future states of the world.
A number of supervisory authorities – both at national and European level – have developed climate change scenarios to assess the exposure of financial institutions to climate risks in terms of transition risks. EIOPA studied several analyses of climate transition scenarios developed by ACPR/Banque de France, DNB, ECB/ESRB as well as EIOPA/2DII to build a conceptual framework for the forward-looking analysis presented in this section. EIOPA’s discussion paper in 2022 briefly summarised these studies21, whereof the main conclusions are:
The assessments make use of different scenarios. ECB/ESRB and ACPR/Banque de France use as a basis the climate scenarios developed by the Network for Greening the Financial System (NGFS), DNB developed its own bespoke shock scenario and the EIOPA/2DII sensitivity analysis makes use of transition scenarios developed by the International Energy Agency (IEA);
The analyses use two ways to measure the impact of disorderly transition scenarios by either comparing them with the baseline results for an orderly transition or with the current, no policy change pathways;
The forward-looking assessments employ several models to translate high-level climate scenarios into pathways for equity and corporate bond prices at sector level using either the NACE breakdown of economic activities or – in case of the EIOPA/2DII sensitivity analysis – fifteen climate-policy relevant activities;
The assessments exhibited substantial differences in exposures to transition risk for the various economic activities and technologies. On the one hand, equity exposures to mining and power generation would be fully stranded in the DNB combined policy and technology shock scenario. On the other hand, equity exposures to renewable energy would double in value in the EIOPA/2DII late and sudden policy shock scenario.
A mapping of the Transition Vulnerability Factors (TVFs) developed by the DNB on the NGFS’s transition risk scenarios to assess the potential exposure of economic activities to transition risks from a forward-looking and risk-oriented perspective. The TVFs capture the sensitivity of stock returns to forward-looking scenario-specific excess market returns, for instance in case of a rise in carbon prices or a technological shock. Based on this mapping exercise, the economic activities that seem to be particularly exposed to transition risk from a forward-looking perspective are the following:
C23 – Manufacture of non-metallic mineral products;
C24 – Manufacture of basic metals;
D35 – Utilities (electricity, gas, steam and air conditioning supply);
H50 – Water transport and
H51 – Air transport.
It is important to differentiate economic activities that might be able to follow a transition to a low carbon economy in the future from those which might not. Indeed, in terms of carbon footprint, sectors related to the extraction, production, processing, transportation and reselling of fossil fuels will hardly be able to reduce their carbon emission levels as it is directly linked with their activity. In this regard, the Platform on Sustainable Finance (PSF) states that “the Platform recognizes there are other economic activities for which no technological possibility of improving their environmental performance to avoid significant harm exists across all objectives and which might be thought of as ‘Always Significantly Harmful’ activities”, referring particularly to economic activities B5 (Mining of coal and lignite), B8.92 (Extraction of peat) and D35.11 (Power generation from solid fossil fuels). According to article 19(3) of the taxonomy regulation, power generation activities that use solid fossil fuels do not qualify as environmentally sustainable economic activities.
Three possible types of transition scenarios can be envisaged in the coming decade:
An orderly type of transition scenario in which there is no or little impact on the real economy and financial sector. This type of scenarios consists of a timely and predictable path to a carbon-neutral economy with companies gradually adjusting their business models and capital stock to this new reality. An orderly transition is considered to be the baseline scenario in the ACPR and ECB/ESRB transition stress tests.
A disorderly type of transition scenario where there is a substantial impact on the real economy and – through their asset exposures to carbon-intensive sectors – the financial sectors. This type of scenarios tends to be characterised by unexpected, sudden and delayed actions to achieve carbon-neutrality. A disorderly scenario is generally considered to be a low probability, but yet plausible event.
A type of scenario where there is no transition or an insufficient transition to a carbon-neutral economy. Such a type of scenarios is also bound to have substantial negative impacts on the real economy and financial sector. Not due to transition risk, but as a consequence of a further increase in (acute) physical risks, like floods, fires and storms that may damage production facilities and disrupt supply chains.26 However, such risk differentials will materialise in another dimension, i.e. depending on the geographical location of companies rather than their carbon sensitivity.
Given that a disorderly transition poses the biggest transition risk, a prudential forward-looking VaR-analysis should focus on transition risk differentials relating to a disorderly scenario. Since it is difficult to estimate the probability of such a scenario, it is proposed to assess its impact under various annual probabilities of occurrence, e.g. ranging from 0.5% to 4.5% per year. To put these annual probabilities into a longer-term perspective, assume for example that the probability of an orderly transition amounts to 50% during the coming decade. The annual probabilities of 0.5-4.5% will then translate in a cumulative probability of 5-30% after 10 years, leaving a cumulative probability of no (or insufficient) transition of 20-45%.
Equity Risk: Backward-Looking Results
Results of the Broad Portfolio Allocation Approach
Results of the Narrow Portfolio Allocation Approach : CPRS (Climate Policy Relevant Sectors) – based Portfolio Allocation)
Overall, the fossil fuel sector shows a differentiated risk profile relative to the other sectors in terms of the highest VaR (-56.5%) in the relevant time period from 2010-2021. This sector includes the following NACE codes: B5, B6, B8.92, B9.1, C19, D35.2, H49.5, G46.71, which mainly relate to activities associated with the extraction of crude oil, natural gas and the mining of coal. A large number of studies underline that these activities, due to their inherent carbon intensity and limited potential to transition, tend to be more exposed to transition risks, as European economies gradually converge towards the objectives set out by the 2015 Paris Climate Agreement and the EU Green Deal.
Equity Risk: Forward-Looking Results
The forward-looking analysis uses the projected equity shocks for the different economic sectors being distinguished in:
the sudden (1) and delayed (2) transition scenarios of ACPR;
the policy shock (3), technology shock (4) and double (or combined) shock (5) scenarios of DNB;
the delayed transition (6) scenario of ESRB/ECB;
the disorderly transition (7) and ‘too little, too late’ (8) scenarios of IAIS.
In the Monte Carlo simulations, if a disorderly transition scenario materialises, a probability of 1/8 is attached to each of these eight specific scenarios occurring.
Equity Risk Differentials (Monte Carlo)
Spread Risk: Backward-Looking Results
Since the aggregation of various different economic activities into high-level portfolios as regards transition risk exposures appears suboptimal for assessing the potential for a risk differential, the assessment focuses on the narrow portfolio approach, in particular regarding fossil fuel-related bonds.
Spread Risk: Forward-Looking Analysis
In line with the forward-looking analysis for equity risk, the transition return shocks for corporate bonds for the different economic activities are derived from the disorderly transition scenarios of ACPR (sudden and delayed transition scenarios), DNB (policy, technology and double shock scenarios), ESRB/ECB (delayed transition scenario) and IAIS (disorderly and ‘too little, too late’ scenarios). In the Monte Carlo simulations, if a disorderly transition scenario materialises, a probability of 1/8 is attached to each of these eight specific scenarios occurring.
Spread Risk Differentials (Monte Carlo)
Stocks and Bonds: EIOPA’s Potential Policy Options
Based on the detailed analysis, EIOPA describes and evaluates three potential options for both asset classes:
Equity Risk (options and EIOPA’s evaluation)
Option 1: “no change”-option
Option 2: treating fossil fuel-related stocks as Type II (stocks listed outside EEA and OCDE markets) equity, i.e., a capital charge of 49% rather than 39% for Type I equities;
Option 3: a dedicated supplementary capital requirement to the current equity risk calibration with supplementary capital charge to the current Standard Formula’s risk charge of 39%, in case of Type I equities, could lie in the range up to 17% in additive terms, i.e., 39%+17%=56%. Regarding the role of participations or long-term equity, exclusion criteria for fossil fuel-related activities or a potentially higher capital requirement may be needed to limit incentives to re-classify Type I/II stocks as participations for the sake of SCR reduction.
Spread Risk (options and EIOPA’s evaluation)
Option 1: no change option.
Option 2: a rating downgrade of bonds related to fossil fuel activities,
Option 3: a dedicated supplementary capital requirement to the current spread risk calibration, up to 5% in additive terms, which corresponds to an increase in the capital requirements of up to 40% relative to the bond portfolio’s current capital requirement.
An impact assessment conducted by EIOPA shows a very low impact of the proposed policy options on the solvency ratio of the undertakings (cumulated range equity and spread on Germany’s and France’s solvency ratios from -0.21 to -1.71%p) mainly due to the undertakings’ limited exposure to directly held fossil fuel-related assets. The low impact on the undertakings’ solvency ratio thereby suggests a limited impact on the asset allocations of undertakings in terms of potentially triggering fire-sales of fossil fuel-related assets that could contribute to systemic risks in the financial system. Moreover, it is important to note that besides capital charges, insurers take further criteria for their investment decisions into account, such as objectives in terms of duration and cash flow matching between assets and liabilities, further limiting the potential of the proposed policy options to trigger material re-allocations in the undertakings’ asset portfolios. It is therefore concluded that the proposed policy options would not materially contribute to systemic risks in the financial system.
Property Risk and Energy Efficiency
Regarding property risk, the Standard Formula in Solvency II currently foresees a shock to the market value of buildings of 25%. The shock has been calibrated as the annual 99.5%-Value-at-Risk (VaR) of monthly total return real estate indices and does not distinguish between commercial or residential real estate.
To study the potential effect of energy efficiency on property risk, EIOPA proposed in its discussion paper to construct property price indices based on samples of buildings with the same energy performance level, while controlling for major property characteristics typically driving the market value of a building. The energy performance-related price indices track the average price series of a specified reference building over time, and allow to calculate the corresponding annual returns. From a prudential perspective on property risk, a comparison of the annual Value-at-Risk values at the 99.5% confidence level across the energy performance-related price indices can provide evidence on a potential energy performance-related risk differential for property risk.
The two main variables of interest for the analysis are the building’s energy performance and its market value. EIOPA suggested in its discussion paper to use the building’s energy performance certificate (EPC) as a categorical measure of its level of energy efficiency. In this regard, the energy performance of a building is defined as the amount of energy needed to meet the building’s energy demand associated with a typical use of the building in terms of heating, cooling, ventilation, hot water and lighting. The EPCs typically range from A+ (most efficient) to H (least efficient), and using EPCs as a determinant for transition risk exposures was broadly supported in the public consultation. Moreover, energy performance certificates are also used as measure for the energy performance of buildings under the corresponding technical screening criteria of the EU Taxonomy.
The building’s market value, measured for the analysis as a building’s advertised sales price, is scaled by the building’s size (typically the square meter of living area for residential buildings) to reduce selection bias and to raise comparability of prices across buildings. Due to the impact of inflation on the market value of buildings, the building’s sales price in a given year is deflated for the analysis.
A range of factors can typically influence a building’s market value, such as location and age, and should be controlled for when grouping comparable buildings together to construct the house price indices. Generally, grouping data in relation to multiple house characteristics to reach homogeneous groups for comparison can materially limit the number of available price observations to construct respective price indices. In particular, residential buildings are typically infrequently sold during their lifetime, constraining materially the scope of building-specific time series data that could be used to track pricing effects. Therefore, a general tradeoff between complexity (granularity) in terms of building characteristics to construct homogeneous groups of buildings and the sample size arises, and a sufficient balance needs to be found.
To study the effect of a building’s level of energy efficiency on property risk from a backward-looking perspective, energy performance-specific property price indices based on the German residential housing market and advertisement data have been constructed.
The findings of EIOPA’s backward and forward-looking analysis together with a risk differentials based sensitivity study show an inconsistent effect of the level of energy efficiency on property risk in terms of the 99.5% Value-at-Risk of annual property returns. In contrast, the forward-looking analysis finds an increase in the riskiness of properties with energy labels F and G, i.e. the two least energy-efficient classes of property.
Since the quantitative findings from a backward- and forward-looking perspective show mixed evidence, EIOPA cannot conclude whether a dedicated prudential treatment of energy efficiency under the property risk sub-module in Solvency II’s Standard Formula could be justified.
As the analysis is subject to various data limitations that could not have been overcome by means of the public consultation of EIOPA’s discussion paper in 2022, EIOPA suggests a repetition of the analysis, particularly in context of the developments of the Energy Performance of Buildings Directive (EPBD), which aims for a consistent assessment of the energy efficiency of buildings in the EU and for improving corresponding data availability. It can therefore be expected that more data suitable for a property risk analysis as regards energy efficiency will be available in future.
Non-Life Underwriting and Climate Change Adaptation
The expected growth in physical risk exposures and insurance claims due to climate change will increase risk-based premium levels over time, potentially impairing the mid- to long-term affordability and availability of insurance products with coverage against climate-related hazards. Moreover, the increased frequency and severity of natural disasters and extreme weather events associated with climate change can make it more difficult for insurers to predict the likelihood of future losses accurately and to price insurance products appropriately.
Climate-related adaptation measures are defined as structural and non-structural measures and services that are implemented by (re)insurance undertakings or policyholders ex-ante to a loss event, which reduce the policyholder’s physical risk exposure to climate-related hazards through
lowering the frequency of climate-related losses or
lowering the intensity of climate-related losses in an underwriting pool.
Climate-related adaptation measures can differ substantially regarding their form and ability to protect against climate-related hazards. Specific examples of climate-related adaptation measures discussed in the insurance context comprise:
measures related to a building’s structure like water-resistive walls, windows and doors or non-return valves on main sewer pipes against flood risk,
external building measures such as sandbags against flood risk,
heat- and fire-resistive construction materials for buildings against exterior fire exposures,
the irrigation of crop fields against drought risk and heat waves and
non-structural measures such as forecasting and warning systems (e.g., SMS) to enable policyholders to protect their goods in advance of severe weather events.
From a risk-based perspective, a clear link between climate-related adaptation measures and insurance premiums is given, as adaptation measures aim to reduce the policyholders’ physical risk exposures and insured losses associated with climate change, and thereby contribute directly to reducing the actuarial fair premium of an insurance contract. In contrast, climate-related mitigation measures focus on actions to reduce greenhouse gas emissions, for which a direct risk-based link to the actuarial fair premium does not necessarily exist. For instance, while motor insurance products focusing on electric vehicles contribute to reducing the emission levels associated with an underwriting pool, the lower emission levels do not directly affect the loss profile of the underwriting pool in terms of the frequency and intensity of claims. Therefore, climate-related mitigation measures are excluded from the scope of this analysis.
The prudential requirements for non-life underwriting risks in Solvency II’s Standard Formula comprise three main modules:
the premium – refers to future claims arising during and after the period of the solvency assessment (covered but not incurred, e.g., in relation to the provision for unearned premiums) – and reserve – refers to past risks and claims that have already materialized (provision for outstanding claims) – risk module,
the catastrophe module – potential losses from extreme and rare tail events, which are expected to happen more frequently and becoming more intense due to climate change – and
the lapse – instantaneous loss of 40% of the in-force business – risk module.
As per EIOPA, Particularly the first two modules can be considered materially sensitive to climate change and its impact on the frequency and intensity of severe weather- and natural catastrophe events. This statement can be challenged as we believe that increasing non affordability of insurance might well have an impact on lapse risk and feed-back on the consultation paper might well add it as being material.
Premium Risk
Premium risk in the Standard Formula is treated by means of a factor-based approach. In particular, the standard deviation of the underwriting pool’s loss ratio, which basically relates to the ratio of claims incurred to premiums earned, is driving the premium risk from a prudential perspective. The capital charge is determined to be consistent with the 99.5% percentile of the loss ratio’s distribution to cover unexpected shocks to the claims and premiums of the insurance undertaking in a given year.
Since climate change and its impact on physical risks materializes dynamically over time, for instance due to the dependance on changes in (global) temperature levels which in turn depend on greenhouse gas emission levels, historic data might not be an appropriate predictor of future trends, making it difficult for insurers to accurately predict the likelihood of future claims.
Climate-related adaptation measures can reduce the frequency and severity of weather- and climate-related losses in an underwriting pool and thereby smooth the claim’s distribution and lower the standard deviation of the loss ratio. In that regard, the risk of mispricing insurance policies due to climate change could be reduced, as the adaptation measures limit the potential for claims realizing in a given year to deviate materially from the expected outcome on which the premium level of the underwriting pool has been set before. The volume measure in terms of the net premiums earned is the second factor in the Standard Formula to determine premium risk from a prudential perspective and can be interpreted as a measure to scale the overall level of premium risk and the corresponding capital charge for the individual insurance undertaking. As the premium level of an underwriting pool is based on the expected volume of claims in a given year, the volume measure covers the expected losses.
Reserve Risk
Reserve risk captures the risk that the absolute level of claims provisions for an underwriting pool could be mis-estimated, i.e., that reserves are not sufficient to settle down the claims that occurred already in the past. As for premium risk, reserve risk is supposed to cover small to medium loss events and not tail events.
The prudential reserve risk is measured by means of a volume measure (net provisions for claims outstanding) and a parameter for standard deviation for the claim payments. Climate-related adaptation measures are expected to reduce the volume measure in terms of the net provisions for claims outstanding. Hence, the expected effect of adaptation measures on insurance reserves will be captured by the volume measure. The variation of costs to settle down claims that have already occurred in the past, however, does not seem to be materially affected by the fact of implementing climate-related adaptation measures in insurance products. Therefore, it is not expected that climate-related adaptation measures will have an impact on the standard deviation parameter driving reserve risk and is therefore studied only qualitatively.
Natural Catastrophe Risk
Under Solvency II, undertakings can take the risk reducing effect of climate-related adaptation measures into account when applying a suitable internal natural catastrophe model for estimating the corresponding capital requirements, but not under the Standard Formula. However, the effects of climate-related adaptation measures on the solvency capital requirements for natural catastrophe risk are difficult to predict, as they depend substantially on the catastrophe model used, the climate-related hazard considered, the risk characteristics of the adaptation measure modelled and the localisation of the risk exposure. Moreover, for example large-scale and expensive adaptation measures like flood-resistant walls might raise materially the value of a building, and thereby raise the sum insured, which in turn will raise the corresponding solvency capital requirement for natural catastrophe risk.
EIOPA focus un Premium Risk
Given the early stage of the EU insurance market regarding the implementation of adaptation measures in insurance products, particularly since current measures usually implemented are rather small-scale measures less effective against tail events captured by the natural catastrophe risk charge, but more effective against small and medium loss events captured by the premium risk charge EIOPA focuses its quantitative analysis on premium risk. Reserve risk and natural catastrophe risk are studied by means of qualitative questions that have been raised in the data collection with insurance undertakings in 2022. Future work could look more deeply into the quantitative influence of adaptation measures on the solvency capital requirements for natural catastrophe risk given further market progress in implementing adaptation measures in insurance products has been achieved providing sufficient data as regards their impact on claims related to tail events.
In order to study the influence of climate-related adaptation measures on premium risk, the annual loss ratios are calculated, both for portfolios with and without adaptation measures based on the 33 responses including data for 15 million policyholders of EIOPA’s 2022 consultation. Data is grouped into three main categories of climate-related adaptation measures for illustrative reasons:
Hail nets, tempered glass and garages, which have a conceptually similar effect against hail risk – referred to as the “Hail protection”-group
Weather warning systems (e.g. SMS, e-mail, etc.) – referred to as the “Warning systems”-group
Other adaptation measures (e.g. building codes) – referred to as the “other adaptation”-group
Standard deviation on Premium Risk
EIOPA’s Summary and Policy Recommendation
The sample for the analysis is very small, as it comprises only eleven underwriting pools. The EU insurance market is at a relatively early stage regarding the implementation of climate-related adaptation measures as defined in this exercise, which naturally limits the amount of potential data to be studied. In this regard, the Standard Formula’s requirement of at least five years of data for the assessment of the standard deviation parameter further constrained the scope of underwriting pools eligible for the analysis. Therefore, it is likely that the data sample studied does not fully capture the effects of adaptation measures, particularly in context of potential variations in terms of adaptation measures, climate perils, spatial exposures, etc.
At this stage, EIOPA does not recommend changing the prudential treatment of premium risk in context of climate-related adaptation measures. Due to the importance of climate-related risk prevention to ensure the long-term availability and affordability of non-life insurance products, EIOPA suggests a repetition of the analysis, provided that the availability of data has improved resulting from further market developments in this regard. In addition, an extension of the prudential analysis to the solvency capital requirements for natural catastrophe risk is suggested.
Social Risks and Impacts from a Prudential Perspective
EIOPA provides an initial analysis of the Pillar II and III requirements under Solvency II, to identify potential areas for further work. Given the material lack of social-related data and risk models regarding the social aspects of investment and underwriting activities of insurers, EIOPA did not conduct a Pillar I-related assessment in response to the mandate.
Social sustainability factors.
Social sustainability factors are commonly referred to in respect of “social and employee matters, respect for human rights, and anti-corruption and anti-bribery matters”.
SFDR (Sustainable Finance Disclosure Regulation) lists the following families of factors also used in the ESRS (European Sustainable Reporting Standards):
Social Impacts
The SFDR social adverse impacts include aspects as gender pay gaps between female and male employees, lack of workplace accident prevention policies, human rights policy or of a diligence process to identify, prevent, mitigate and address adverse human rights impacts.
The Social Taxonomy Report issued by the Platform on Sustainable Finance identifies as examples of socially harmful economic activity the involvement with certain kinds of weapons or the production and marketing of cigarettes.
Social Risks
Social risks refer to (financial) risks including those deriving from dependencies on human and social resources and those affecting working conditions and living standards, communities and consumers / end-users.
Social risks can arise from (macro-level) socio-economic developments as well as from entities or individual behaviour.
They can transmit into society
directly (e.g. events causing unemployment, health or security issues (such as pandemics, cyber threats)),
indirectly (‘second order’, e.g. rising price levels leading to financial distress, the risk of unemployment spreading into health or safety risks) and
through spill-over impacts (‘contagion’) affecting, for example, the financial system (e.g. unemployment leading to mortgage defaults, resulting in increased mortgage insurance pay outs and causing potential financial sector stability issues).
These risks can then transmit into risks for (re)insurance activities. For example, economic difficulties could lead to a decrease in the ability of citizens and companies to insure themselves or to pay their premiums.
Social Transition and Physical Risks
Social transition risk can result from the misalignment of economic activities with changes in policy, technology, legal requirements or consumer preferences which aim at addressing social negative impacts, such as for example inadequate working conditions or discrimination.
While social risks are primarily non-physical in nature, they can also give rise to physical / mental health consequences, especially when they affect working, safety and living conditions. Social risks related to inequality, discrimination, or human rights abuses can also for example lead to social conflicts which may have physical consequences in the form of property damage resulting from violence.
Social Risks for Insurers from a Prudential Perspective
Social risks can translate into prudential risks in the form of underwriting, market, operational (incl. legal) or reputational risks.
Pillar I Prudential Treatment
To perform a quantitative analysis to assess the potential for dedicated capital charges related to social risks, in line with risk- and evidence-based principles, would require large (international) consensus on appropriate definitions of risk channels as well as comprehensive and granular data on social risk factors in conjunction with appropriate risk models, which are not available to date. Hence, EIOPA does not conduct a Pillar I-related analysis in response to the expected mandate.
Pillar II Prudential Treatment
This chapter of EIOPA’s consultation clearly favours ORSA as being today’s most appropriate tool to deal with Social Risk Management. We agree with this initial strategy as it will enable regulators to build a real framework potentially impacting Pillar I and III within the next two to three years. However, based on the recent experience with ORSA, it would be useful to guide (re)insurance undertakings once the first ORSA reports including these issues filed to NCA. A Dry Run ORSA including these new criteria – like the one we experienced prior to 2016 – could be a good strategy to meet expectations.
High level social risk materiality assessment
(Re)insurers can conduct a high level (qualitative) social risk materiality assessment based on exposure to geographies, sectors or lines of business. The materiality of the exposure would form a proxy to vulnerability and materiality of the risk, in a first step of a risk materiality assessment.
Social risk – geographical exposure. For example, the Allianz social risk index118 identifies countries that are most vulnerable to systemic social risk. Indicators providing measures for social inequality or development can also provide indications on geographical exposure to social risks, such as the World Bank’s World Development Indicators featuring among others social indicators on labor, health, gender; the Gini index measures the distribution of income across a population; the UNDP human development indicator summarizes achievement in key dimensions of human development across countries.
Social risk – sectoral exposure. The exposure of assets or liabilities to economic activities in ‘high social risk sectors’. For example, the Business and Human Rights Navigator (UN Global Compact) can help mapping exposure to sectors at high risk of relying on child labour, forced labour, or sectors negatively impacting on equal treatment (incl. restrictions to freedom of association) or on working conditions (inadequate occupational safety and health, living wage, working time, gender equality, heavy reliance on migrant workers) or have negative impacts on indigenous people. For these issues, the Navigator identifies industry-specific risk factors, aiming to illustrate the issue for certain sectors such as agriculture, fashion & apparel, mining, travel & tourism. The navigator also identifies due diligence steps that companies can take to eliminate the specific social risks in their operations and supply chains. Information on the social sustainability of the economic activity the insurer is underwriting or investing in, can be sourced from companies’ corporate reporting on social risks and impacts under the Corporate Sustainability Reporting Directive (CSRD), as will be implemented by the European Sustainability Reporting Standards.
Social risk – insurance lines of business exposure. Some insurance lines of business may be particularly exposed to social risks. For example, the PSI ESG Underwriting Guide for Life and Health Insurance123 and the Geneva Association’s heat map of potential ESG risks in property and casualty underwriting124 identify social factors that may (negatively/positively affect) health or life and non-life insurance risks. Social adversity and lifestyle behaviour is known to affect health and with it, potential health insurance claims. Workers’ compensation claims are likely to be at risk of an employer’s poor work force policies. Other social/societal factors, such as housing insecurity or lack of education can influence (in)directly the outcome of workers’ compensation claims.
Practices for Mitigating Social Risks & Impacts: The Investment Strategy and Decisions
Limiting investment in or divesting from socially non-sustainable activities/companies: The exclusion of an investee harming social objectives from the investment portfolio can follow the identification of a socially harmful activity, based on two sources: internationally agreed conventions (e.g., certain kinds of weapons) or research on the detrimental effects of certain activities (e.g., detrimental effect of tobacco use). Thresholds for investments in such companies can be set, or exclusions from investments in these sectors pursued. Minimum social safeguards can serve as a guiding principle.
Impact investing and stewardship:
The (impact) investment strategy would direct investments at economic activities aiming to achieve explicitly social goals. For example, the funding of health research, through targeted investments in dedicated undertakings or investment in financial literacy programs may contribute to social objectives to improve living standards or access to relevant products to secure financial safety.
Engagement and voting on sustainability matters (as part of a stewardship approach) can aim to influence firms of which (re)insurers are shareholders. This supposes the (re)insurer can persuade the investee to act on social objectives and requires a certain degree of influence or leverage that the (re)insurer can reasonably exercise. (Re)insurers can use their engagement and voting rights to improve performance of those companies against the social objectives.
A ‘best-in-class strategy’ would consist in selecting investee companies with excellent social performance, regardless of the sector which they belong to. Such an investment approach can support companies to transition to a more socially sustainable business model. (Re)insurers can seek to ensure that those firms they invest in measure up to social objectives, especially in ‘high risk’ sectors, ensuring, for example that they provide appropriate wages, or that they operate safe working environments.
Such risk mitigating or adaptation actions can be informed by considering the SFDR principal adverse impacts of the investee companies’ activities. The so-called ‘minimum social safeguards’ as referred to in the Taxonomy Regulation can also provide a minimum standard for implementing a social prudent person principle for investments, in line with Solvency II.
Practices for Mitigating Social Risks & Impacts: The Underwriting Strategy and Decisions
Limiting underwriting of socially non-sustainable activities: Similar to investments, insurers could opt not to insure companies (belonging to a sector) known for unsustainable or harmful social practices in its own operations or value chain, or negatively impacting communities or consumers.
Impact underwriting and services: Through targeted underwriting activity, products and services, insurers could bring additional social benefits that directly contribute to the realization of social objectives for end-users and consumers as well as for affected communities (directly or through the value chain). There may be scope for insurers, through their underwriting strategy and decisions, to incentivize policyholders to manage losses arising from social risks. This may be through the provision of services or the potential reduction of premia for risk reducing measures taken by the policyholder, consistent with actuarial risk-based principles. Via underwriting, insurers could also ensure their product offerings and distribution practices consider the demands and needs of a diverse range of clients. Through their underwriting they need to ensure exclusions do not unfairly target and discriminate consumers with non-normative traits and/or vulnerable consumers.
For example:
The integration of social risk mitigants into, for example, surety bond underwriting for infrastructure projects can also contribute to reducing losses from underwriting due to social risks.
Risk mitigants can be part of underwriting conditions for workers’ compensation policies requiring companies to impact on the health of their workers through the pay they provide, the security of contracts they offer, and through the provision of benefits such as sick pay, parental leave, health insurance and other health-related schemes.
The establishment of sectoral risk sharing capacities at local, regional or national level, where applicable with government involvement, can contribute to social risk mitigation, for example by improving risk assessment for communities and societies and reducing losses from socio-economic risk events.
Pillar III Prudential Treatment
Considering the nascent reporting requirements on social risks and impacts under SFDR and CSRD, EIOPA is not proposing at this stage to develop additional (prudential Pillar III) reporting or disclosurerequirements regarding social risks and impacts in Solvency II. Further analysis would be required as to whether quantitative prudential reporting requirements could inform the corresponding prudential treatment of (re)insurers assets and liabilities.
On 10 November 2022, the European Parliament voted to adopt a new EU regulation on digital operational resilience for the financial sector (DORA). With obligations under DORA coming into effect late in 2024 or early 2025 at the latest, in this briefing we take a closer look at its impact and consider what the regulation will mean for firms, their senior managers and operations and what firms should be doing now in preparation for day one compliance.
What is DORA?
Aimed at harmonising national rules around operational resilience and cybersecurity regulation across the EU, DORA establishes uniform requirements for the security of network and information systems of companies and organisations operating in the financial sector as well as critical third parties which provide services related to information communication technologies (ICT), such as cloud platforms or data analytics services.
DORA creates a regulatory framework on digital operational resilience whereby all in-scope firms need to make sure that they can withstand, respond to, and recover from, all types of ICT-related disruptions and threats. ICT is defined broadly to include digital and data services provided through ICT systems to one or more internal or external users, on an ongoing basis.
DORA forms part of the EU’s Digital Finance Package (DFP), which aims to develop a harmonised European approach to digital finance that fosters technological development and ensures financial stability and consumer protection. The DFP also includes legislative proposals on markets in cryptoassets (MiCA), distributed ledger technology and a digital finance strategy.
Who will need to comply with DORA?
DORA will apply to financial entities, including:
credit institutions,
payment institutions,
e-money institutions,
investment firms,
cryptoasset service providers (authorised under MiCA) and issuers of asset-referenced tokens,
central securities depositories,
central counterparties,
trading venues,
trade repositories,
managers of alternative investment funds and management companies,
data reporting service providers,
insurance and reinsurance undertakings,
insurance intermediaries,
reinsurance intermediaries and ancillary insurance intermediaries,
institutions for occupational retirement pensions,
credit rating agencies,
administrators of critical benchmarks,
crowdfunding service providers and
securitisation repositories (Financial Entities).
DORA will also apply to ICT third-party service providers which the European Supervisory Authorities (the European Banking Authority (EBA), the European Securities and Markets Authority (ESMA) and the European Insurance and Occupational Pensions Authority (EIOPA), acting through their Joint Committee) (ESAs) designate as « critical » for Financial Entities (Critical ICT Third-Party Providers) through a newly established oversight framework.
The ESAs would make this designation based on a set of qualitative and quantitative criteria, including:
the systemic impact on the stability, continuity or quality of financial services in the event that the ICT third-party provider faced a large-scale operational failure to provide its services;
the systemic character or importance of Financial Entities that rely on the ICT third-party service provider;
the degree of reliance of those Financial Entities on the services provided by the ICT third-party service provider in relation to critical or important functions of those Financial Entities; and
the degree of substitutability of the ICT third-party service provider.
Any ICT third-party service provider not designated as critical would have the option to voluntarily « opt in » to the oversight. The ESAs may not make a designation in relation to certain excluded categories of ICT third–party service providers, including where Financial Entities are providing ICT services
to other Financial Entities,
to ICT third–party service providers delivering services predominantly to the entities of their own group or
to those providing ICT services solely in one Member State to financial entities that are active only in that Member State.
What are the key obligations?
DORA introduces targeted rules on ICT risk management capability, reporting and testing, in a way which enables Financial Entities to withstand, respond to and recover from ICT incidents. In principle, some of the requirements imposed by DORA, such as for ICT risk management, are already reflected to a certain extent in existing EU guidance (for example, the EBA Guidelines on ICT and security risk management).
The proposals include requirements relating to:
ICT risk management
DORA sets out key principles around internal controls and governance structures. A Financial Entity’s management body will be expected to be responsible for defining, approving, overseeing and being continuously accountable for a firm’s ICT risk management framework as part of its overall risk management framework. As part of the ICT risk management framework, Financial Entities need to maintain resilient ICT systems, revolving around specific functions in ICT risk management such as
identification of risks,
protection and prevention,
detection,
response and recovery and
stakeholder communication.
Reporting of ICT-related incidents
DORA aims to create a consistent incident reporting mechanism, including a management process to detect, manage and notify ICT-related incidents. Incidents deemed « major » would need to be reported to competent authorities within strict time frames, including initial notifications « without delay » on the same day or next day by using mandatory reporting templates. In some cases, communication to service users or customers may be required.
Testing
As part of the ICT risk management framework, DORA requires Financial Entities to adopt a robust and comprehensive digital operational resilience testing programme covering ICT tools, systems and processes. Certain Financial Entities must carry out advanced testing of their ICT tools, systems and processes at least every three years using threat-led penetration tests.
Information sharing
DORA contains provisions which should facilitate the sharing, among Financial Entities, of cyber threat information and intelligence, including
indicators of compromise,
tactics,
techniques and procedures,
cyber security alerts and
configuration tools
to strengthen digital operational resilience.
Localisation
Financial Entities will only be permitted to make use of the services of a third-country Critical ICT Third-Party Provider if such provider establishes a subsidiary in the EU within 12 months following its designation as a Critical ICT Third-Party Provider.
A simplified set of ICT risk framework requirements will apply to certain Financial Entities, including small and non-interconnected investment firms and payment institutions exempted under the Second Payment Services Directive. Such entities will need to comply with a reduced set of requirements under DORA, including the requirement to put in place and maintain a sound and documented risk management framework that details the mechanisms and measures aimed at a quick, efficient and comprehensive management of all ICT risks, including for the protection of relevant physical components and infrastructures.
What should firms be doing now to prepare?
Although it is not expected that DORA will apply to in-scope entities until late 2024 (see below), firms should now begin considering the steps that they will need to take to ensure day one compliance. These include:
Scope out impact
Taking a risk-based approach reflective of their size, nature, scale and the complexity of their services and operations, Financial Entities should begin to scope out the impact of DORA on their business. Firms should carry out a comprehensive gap analysis of their existing ICT-risk management processes against the new requirements introduced by DORA to identify any aspects of their existing processes that will be impacted by the new requirements and develop detailed implementation plans setting out the steps that will need to be taken to effect relevant changes. As part of this, Financial Entities should ensure that they have in place appropriate:
(i) capabilities to enable a strong and effective ICT risk management environment;
(ii) mechanisms and policies for handling all ICT-related incidents and reporting major incidents; and
(iii) policies for the testing of ICT systems, controls and processes and the management of ICT third-party risk.
This process will be iterative as some of the more detailed requirements of DORA will be further developed through technical standards to be published by the ESAs in due course.
Critical ICT Third-Party Providers
Critical ICT Third-Party Providers will be required to have in place comprehensive, sound and effective rules, procedures, mechanisms and arrangements to manage the ICT risks which they may pose to Financial Entities. Although DORA provides that the designation mechanism (pursuant to which the ESAs may designate an ICT third-party service provider as « critical ») must not be used until the Commission has adopted a delegated act specifying further details on the criteria to be used in making such an assessment (to be adopted within 18 months after the date on which DORA enters into force), it is expected that certain categories of providers, such as cloud computing service providers who provide ICT services to Financial Entities, will be designated as Critical Third-Party Providers.
Consequently, such providers may wish to begin the task of benchmarking their existing systems, controls and processes against existing guidelines, such as the EBA Guidelines on ICT and security risk management and Guidelines on outsourcing arrangements, to the extent required, to identify areas that require further investment and maturity. They will also need to consider whether new and existing contracts give them sufficient flexibility to comply with new regulatory rules, orders and directions, even if this would otherwise be inconsistent with their contractual obligations. As set out above, certain categories of ICT third-party service providers are expressly excluded from the designation mechanism, including Financial Entities providing ICT services to other Financial Entities, ICT intra-group service providers and ICT third-party service providers providing ICT services solely in one Member State to Financial Entities that are only active in that Member State.
Third Country Critical ICT – Third-Party Providers – Subsidiarisation
The EU subsidiarisation requirement that will apply to third country Critical ICT Third-Party Providers is one that will necessitate early engagement between such providers and the Financial Entities that they serve. While it is not clear what role the EU subsidiary must play in the provision of services to the relevant Financial Entity (e.g. whether the provider must act as contractual counterparty), Recital 58 of DORA indicates that the requirement to set up a subsidiary in the EU does not prevent ICT services and related technical support from being provided from facilities and infrastructures located outside the EU. Nevertheless, where a relevant third country ICT third-party provider that is likely to be designated as « critical » indicates that it does not intend to establish a subsidiary in the EU, even following a designation as such by the ESAs, Financial Entities may wish to commence the process of identifying alternative providers, since they will not be permitted to obtain ICT services from a third country Critical ICT Third-Party Provider that fails to establish a subsidiary in the EU within 12 months following its designation as critical.
Companies that consider they are likely to be classified as Critical ICT Third-Party Providers that do not already have an establishment or subsidiary located in the EU should begin to consider now which Member State would be most appropriate to establish a new subsidiary in, taking into account their business operations and the various applicable legal requirements.
Documentation impact
As noted above, DORA sets out core contractual rights in relation to several elements in the performance and termination of contracts with a view to enshrine certain minimum safeguards underpinning the ability of Financial Entities to monitor effectively all risk emerging at ICT third-party level. Some contractual requirements set out in DORA are mandatory and will need to be included in contracts, if not already reflected. Others take the form of principles and recommendations and may require negotiation between the relevant parties. Early mapping and engagement in this respect will be important. Additionally, parties may wish to consider benchmarking their existing contractual arrangements against relevant requirements set out in DORA, as well as existing standard contractual clauses developed by EU institutions.
For example, Recital 55 of DORA notes that « the voluntary use of contractual clauses developed by the Commission for cloud computing services may provide comfort for Financial Entities and ICT third-party providers by enhancing the level of legal certainty on the use of cloud computing services in full alignment with requirements and expectations set out by the financial services regulation ».
As the industry awaits more detailed technical standards to be developed and published by the relevant ESAs, as well as DORA compromise/Level 1 text, in-scope entities may consider using existing guidelines such as the EBA Guidelines on ICT and security risk management and Guidelines on outsourcing arrangements as useful benchmarking tools in preparation for day one compliance.
How does DORA interact with NIS2?
The second iteration of the Security of Network and Information Systems Directive (NIS2) aims to strengthen security requirements and provide further harmonisation of Member States’ cybersecurity laws, replacing the original NIS Directive of 2016 (NIS1). Its timeline is similar to that for DORA, with a provisional agreement among EU institutions reached in May 2022, and its adoption confirmed in a European Parliament plenary session vote on 10 November 2022. NIS2 significantly extends the scope of NIS1 by adding new sectors, including « digital providers » such as social media platforms and online marketplaces, for example, but importantly also introduces uniform size criteria for assessing whether certain financial institutions (and other entities) fall within its scope. NIS2 sets out cybersecurity risk management and reporting obligations for relevant organisations, as well as obligations on cybersecurity information sharing, so there is some overlap in coverage with DORA.
However, this has been addressed during the legislative process to ensure that financial entities will have full clarity on the different rules on digital operational resilience that they need to comply with when operating within the EU. NIS2 specifically provides that any overlap will be addressed by DORA being considered as lex specialis (ie a more specific law that will override the more general NIS2 provisions).
How does DORA compare with international developments?
The introduction of DORA in the EU reflects a global focus on operational resilience and strengthening cybersecurity standards in the wake of ever-increasing digitalisation of financial services and increasingly sophisticated cyber incidents. For example, in March 2021, the Basel Committee on Banking Supervision issued its Principles for operational resilience, as well as an updated set of Principles for the sound management of operational risk (PSMOR), which aim to make banks better able to withstand, adapt to and recover from severe adverse events.
In October 2022, following a G20 request, the Financial Stability Board (FSB) published a consultation on Achieving Greater Convergence in Cyber Incident Reporting, recognising that timely and accurate information on cyber incidents is crucial for effective incident response and recovery and promoting financial stability and with a view to ensuring that financial institutions operating across borders are not subject to multiple conflicting regimes. The FSB proposals include recommendations to address the challenges to achieving greater international convergence in cyber incident reporting, work on establishing common terminologies related to cyber incidents and a proposal to develop a common format for incident reporting exchange.
Following its departure from the EU, the UK has introduced a Financial Services and Markets Bill (the UK Bill) which includes proposals to regulate cloud service providers and other critical third parties supplying services to UK regulated firms and financial market infrastructures. HM Treasury would have powers to designate service suppliers as ‘critical’ and the UK regulators would have new powers to directly oversee designated suppliers, which would be subject to new minimum resilience standards. While the proposals have the same ambitions as, and there are similarities with, the requirements under DORA, there are a number of key differences between them.
For example, the proposed enforcement regime under DORA for Critical ICT Third-Party Providers is very different from the equivalent regime proposed by the UK Bill. Under DORA, the ESAs will be designated as « Lead Overseers », but with the power only to make ‘recommendations’ to Critical ICT Third-Party Providers, in contrast to the ability for UK regulators to make rules applying to, or to give directions to, critical third parties subject to the UK Bill, with the ability to issue sanctions for non-compliance. Under DORA, non-compliance by a Critical ICT Third-Party Provider with recommendations gives the Lead Overseer the ability to notify and publicise such non-compliance and « as a last resort » the option to require Financial Entities to temporarily suspend services provided by such provider until the relevant risks identified in the recommendations have been addressed.
This means that the liability and contractual issues for Critical ICT Third-Party Providers providing services in the EU will be different than for those providing services in the UK, and that contracts for each will need to be considered and negotiated carefully.
Next steps and legislative timeline
Following adoption of DORA by the European Parliament plenary session on 10 November 2022, the regulation is now passing through the final technical stages of the formal procedure for European legislation. The text still needs to be formally approved by the Council of the EU before being published in the Official Journal, which is expected in December 2022 or January 2023.
DORA will come into effect on the twentieth day following the day on which it is published in the Official Journal. It will apply, with direct effect, 24 months from the date on which it enters into force. Therefore, it is expected that DORA will apply to in-scope firms from late 2024 or early 2025 at the latest.
EXECUTIVE SUMMARY AND POLICY ACTIONS The recovery associated with the receding pandemic has slowed as a result of the Russian aggression in Ukraine. It has contributed to high inflation and is damaging the economic outlook, which led to increased financial market risks across the board. The economic and financial impact of the invasion has been felt globally, alongside enormous humanitarian consequences. Prices in energy and commodity markets have risen to record highs. Production and logistics costs have risen and household purchasing power has weakened. After a long period characterized by very low inflation and interest rates, policy rates are being raised in response to high inflation. The resulting higher financing costs and lower economic growth may put pressure on the government, and on corporate and household debt refinancing. It will likely also have negative impact on the credit quality of financial institution loan portfolios. Financial institutions are moreover faced with increased operational challenges associated with heightened cyber risks and the implementation of sanctions against Russia. The financial system has to date been resilient despite the increasing political and economic uncertainty.
In light of the above risks and uncertainties, the Joint Committee advises national competent authorities, financial institutions and market participants to take the following policy actions:
Financial institutions and supervisors should continue to be prepared for a deterioration in asset quality in the financial sector. In light of persistent risks that have been amplified by the Russian invasion and a deteriorating macroeconomic outlook, combined with a build-up of medium-term risks with high uncertainty, supervisors should continue to closely monitor asset quality, including in real estate lending, in assets that have benefitted from previous support measures related to the pandemic, and in assets that are particularly vulnerable to rising inflation and to high energy- and commodity prices.
The impact on financial institutions and market participants more broadly from further increases in policy rates and the potential for sudden increases in risk premia should be closely monitored. Inflationary pressures coupled with uncertainty on risk premia adjustment raise concerns over potential further market adjustments. Rising interest rates and yields are expected to improve the earnings outlook for banks given their interest rate sensitivity. They could also reduce the valuation of fixed income assets, and result in higher funding costs and operating costs, which might affect highly indebted borrowers’ abilities to service their loans. Credit risks related to the corporate and banking sector also remain a primary concern for insurers and for the credit quality of bond funds. High market volatility stemming from the above economic and geopolitical situation could also raise short-term concerns and disruptions for market infrastructures.
Financial institutions and supervisors should be aware and closely monitor the impact of inflation risks. The economic consequences of the Russian aggression mainly channel through energy and commodity markets, trade restrictions due to sanctions and the possible fragmentation of the global economy. Financial fragmentation, including fragmentation of funding costs, could threaten financial stability and put pressure on price stability. Inflation is not only relevant from a risk perspective, but is expected to reflect also on the actual benefits and pensions, inflationary trends should be taken into account in the product testing, product monitoring and product review phases. Financial institutions and regulators should make extra efforts to ensure investor awareness on the effects of inflation on real returns of assets, and how these can vary across different types of assets.
Supervisors should continue to monitor risks to retail investors some of whom buy assets, in particular crypto-assets and related products, without fully realizing the high risks involved. Some retail investors may not be fully aware of the long-term effects of rising inflation on their assets and purchasing power. In the context of growing retail participation and significant volatility in crypto-assets and related products, retail investors should be aware of the risks stemming from these. The recent events and subsequent sell-off of crypto assets raises concerns on the appropriate assessment of the risks and the developments of this market segment going forward and requires particular attention of financial institutions and supervisors. Where disclosures are ineffective, these risks are compounded.
Financial institutions and supervisors should continue to carefully manage environmental related risks and cyber risks. They should ensure that appropriate technologies and adequate control frameworks are in place to address threats to information security and business continuity, including risks stemming from increasingly sophisticated cyber-attacks.
1 MARKET DEVELOPMENTS The Russian invasion and inflationary pressures have significantly impacted the risk environment of EU securities markets. Recoveries in most equity indices from the beginning of 2022 came to a halt, following the March 2020 market stress, with global equity indices broadly declining (in 1H22: Europe -18%, China -8%, US -20%). This was mostly linked to energy costs and lower trade flows due to the Russian invasion, supply-side bottlenecks linked to the continued effects of the COVID-19 pandemic and the tightening of credit conditions for firms. At the same time, volatility as measured by the European volatility index VSTOXX rose in early March (41%) to about half the levels of March 2020. In Europe, more energy intensive sectors, such as consumer discretionary (-31% YTD), industrials (-29%), and technology (-36%), saw larger price falls than other sectors. Price-earnings ratios tumbled, though they remained above 10-year historical averages (at 3% EU and 9% US respectively). The decreases partly reflect lower earnings expectations for the future, due to the potential long term effects of the pandemic and the impacts of higher long-term interest rates.
Fixed income markets were characterized by investor expectations of slower economic growth, higher inflation and a less accommodating interest rate environment. Despite a short-lived fall right after the invasion, EU sovereign bond yields rose in 1H22 to levels unseen since 2016 with significant news-flow related volatility (IT +213bps, GR +230bps, DE +150bps). As of end-June, spreads to the Bund also widened, e.g. for Italy (1.9%, +70bps) and Spain (1.1%, +39bps). Corporate bond markets showed sensitivity to the evolving outlook, recording significant selloffs across all rating categories and reduced liquidity. Investment grade (IG) bonds experienced a peak-to-trough fall of 15% (August 2021 to May 2022), nearly twice that of the pandemic, and declined by 12% in the year to June. High-yield (HY) bonds performed slightly worse (‑15%) but their peak-tot rough losses were lower than during the pandemic. Credit spreads widened on concerns that the slowdown could weigh on firms’ debt capacity. Significant spreads upswings were also seen in February with the invasion, and in May and June as rates hikes occurred in the US and were announced for the EA.
The crypto-asset market experienced a continued sell-off in 2Q22 in line with the decline of traditional financial assets (especially tech equities) with which Bitcoin (BTC) shares a close (40%) correlation. The collapse of crypto-asset TerraUSD in May and the pausing of customer withdrawals by crypto-asset Celsius in June, added to the shift in investor sentiment away from these assets, sending BTC price to an 18-month low. In May, the largest algorithmic stablecoin (third largest overall), TerraUSD, failed to maintain its peg to the USD after its underlying decentralised finance (DeFi) protocol, Anchor, suffered a confidence run on its deposits. The combination of the sharp fall in crypto-asset prices, and the demise of the Anchor protocol linked to TerraUSD, caused the total value of assets ‘locked’ (deposited) in DeFi smart contracts to fall from over EUR 186bn at the start of May to EUR 62bn by June. In another development in June, centralized finance (CeFi) lending platform, Celsius, halted customer withdrawals of deposits, signaling that it had liquidity issues or a deeper insolvency problem. This coincided with a 21% fall in the Bitcoin price and led Binance to temporarily suspend Bitcoin withdrawals from its exchange. The Celsius token price had fallen by 94% since the start of 2022 with market speculation that it could sell a sizeable stake in crypto asset Ethereum to avoid collapse.
The turmoil triggered by the Russian invasion also affected environmental, social and governance (ESG) markets. In 1Q22, EU ESG equity funds had net outflows of EUR 5bn, compared with average inflows of EUR 11bn per quarter in 2021. ESG bond issuance volumes fell 29% from the start of the year to June, as compared with the same period in 2021. In the banking sector, ESG bond issuance as a share of total bond issuance decreased compared to 2021, though they often enjoy higher subscription levels than non-ESG bonds, allowing banks to pay lower risk premia on new issuances. Despite this, some fundamental factors driving the rise of ESG investing remain in place. Most importantly, investor preferences continue to shift towards sustainable investments, with portfolio allocations increasingly tilted towards ESG investments. Similarly, issuance of ESG bonds by EU corporates remained on par with early 2021, supported by a rapid expansion of the sustainability-linked bond market. This contrasts with a 32% fall in broader EU corporate bond issuance.
2 DEVELOPMENTS IN THE FINANCIAL SECTOR In 1H22, European investment funds faced heightened volatility in securities markets given the increasingly uncertain economic outlook and the expected increase in interest rates. The performance of most EU fund categories dropped significantly, from a 12-month average monthly performance of 1.6% for equity funds in December 2021 to 0.9% in June 2022. In the meantime, the performance of bond funds turned negative (-0.7%). In contrast, commodity funds outperformed the sector in 1Q22, reflecting the surge in commodity prices following the Russia’s invasion of Ukraine and the sanctions on Russia, before slightly receding, to 2.1%, in end-June. Equity fund flows were also negative (-0.9%). Declining performance led to redemption requests with net outflows in 1H22 totalling 1.6% of the net asset value (NAV) of the fund sector. Bond funds were particularly affected (-4.8% NAV) due to negative performance (-0.7%) and exposures to growing credit and interest risks. Commodity funds experienced outflows (-5.8%), albeit from a low base and only in 2Q22, when their performance declined. MMFs funds also experienced substantial outflows ( -9.2% NAV exceeding the -4.6% NAV observed during COVID-19 stress). MMFs denominated in all currencies experienced outflows, though USD MMFs experienced higher returns (1.1% average monthly performance) than EUR denominated MMFs (-0.1%). While MMFs may generally benefit from a flight-to-quality during uncertain market conditions, investors currently appear to be turning away from fixed-income funds in general. Outflows were partly driven by the expected increase in interest rates. In contrast, real estate funds (1.7% of NAV) and mixed funds (1% of NAV) recorded inflows in 1H22.
The European insurance sector entered 2022 in good shape notwithstanding the adverse developments since the COVID-19 outbreak. During 2021, gross written premiums (GWP) for the life business grew (y-o-y) quite substantially (+14%), while growth was lower for the non-life business (8%). The positive change has partially been driven by the previous reduction in GWP throughout 2020 during the pandemic; although GWP remain still below pre-Covid levels, in particular for life business. The good performance of financial markets and the high returns obtained during 2021 pushed insurer’s profitability up to the levels reached back in 2019, with a median return on assets standing at 0.57% in 4Q21 (0.38% in 4Q20).
At the beginning of 2022 insurers’ capital buffers on aggregate were solid with a median SCR ratio of 216%. An improvement was observed for life insurers while a slight decline was observed for non-life insurers. As the risk-free interest rate increased throughout 2021, due to the long maturities of life insurers’ liabilities the value of technical provision decreased relatively more than the value of assets, with a positive effect on net capital. This contributed to an increase the median SCR ratio for life insurers, from 216% to 225%. However, the SCR ratio did not reach the high levels observed at the end of 2019 (236%). On the other hand, the median SCR ratio for non-life insurers slightly decreased from 218% towards 211%. This might be driven by the increase in claims negatively affecting the liabilities of some representative undertakings, combined with the fact that asset values declined more than liabilities when interest rates increased given that non-life insurers tend to be characterized by a positive duration gap. Likewise, the financial position of EEA IORPs displayed a recovery in 2021. The total amount of assets grew to EUR 2,713 bn in 4Q21 (From EUR 2,491 bn. in 4Q20), while liabilities remained more or less unchanged. Similarly, the Excess of Assets over Liabilities exhibited a positive trend.
The European banking sector entered 2022 with relatively strong capital- and liquidity positions. The capital ratio (CET1 fully loaded) is, at 15.0% in 1Q22, at the same level as it was before the pandemic broke out (in 4Q19). Yet the capital ratio was 50bps lower than in the previous quarter, mainly driven by rising risk weighted assets (RWA). After a steadily rise in previous quarters, the liquidity coverage ratio (LCR) also slightly deteriorated in 1Q22. A reported LCR ratio of 168.1% in 1Q22 (174.8% in 4Q21) was nevertheless still substantial.
EU banks are facing additional challenges to asset quality and profitability while pandemic-related vulnerabilities continue to loom. Deteriorating economic prospects, high uncertainties and high inflation with a phasing-out of accommodative monetary policy are affecting the outlook for EU banking sector. Loan portfolios with pre-existing vulnerabilities from disruptions caused by the pandemic may also be further affected in a slower economic recovery. Accordingly, 45% banks responding to the EBA’s spring 2022 risk assessment questionnaire (RAQ) indicated their plans to maintain their overlays related to the pandemic to cover potential losses that may materialize in the next quarters, while 35% of banks indicated plan to release them fully or partially. Supervisors should continue to closely monitor the adequacy of banks’ provisions.
The NPL ratio further improved in the first quarter of the year (to 1.9%), mainly driven by decreasing volumes of non-performing loans (NPL). However, rising cost of risks and an increasing share of loans allocated under Stage 2 under IFRS points to slightly deteriorating asset quality. The quality of loans under previous support measures related to the pandemic continues to show signs of deterioration and also requires vigilance. The total volume of loans with expired EBA-compliant moratoria reached EUR 649bn in 1Q22, a 7.8% decline compared to the previous quarter. The volume of subject to public guarantee schemes (PGS) stood at EUR 366bn in 1Q22, almost unchanged compared to the previous quarter. The NPL ratio of loans under expired moratoria and of loans subject to PGS is, at 6.1% and 3.5% in 1Q22, respectively, substantially higher than the overall NPL ratio, and has increased further since 4Q21. PGS loans are mostly concentrated to a few countries only. The allocation of Stage 2 under IRFS 9 for loans under previous support measures is, at 24.5% for loans under expired moratoria and 22.7% for loans subject to PGS, substantially higher than stage 2 allocations for all loans and advances (9.1% in 1Q22). In spite of their slight deterioration in 1Q22, EU banks’ capital and liquidity positions nevertheless provide, for the time being, sufficient cushioning in banks’ balance sheets should the economic situation deteriorate further, or heightened market volatility persist.
Positive operating trends were observed for European banks in 1Q 2022, with a profitability of 6.6% return on equity (ROE) achieved under difficult market conditions, though this is lower than the 7.7% ROE reported in the previous year (1Q21) and lower than the 7.3% ROE of the previous quarter. The contraction can be explained mainly by rising contributions to deposit guarantees schemes and resolutions funds in some countries and various one-off effects, whereas net operating income improved. In 1Q21, lending growth offset a slight decline in net interest margins (NIM) and led to improved net interest income (NII). Net trading income also increased, supported by market volatility. Overall increasing net operating income also outweighed the impact of rising inflation on operating expenses in the first quarter of 2021.
3 IMPACT OF RU-UA WAR ON THE EUROPEAN FINANCIAL SECTORS Securities markets experienced volatility with some key commodity markets strongly impacted by the Russian invasion and sanctions. Bond yields rose in response to the increasing inflation and anticipated higher rates, while equity markets were volatile and experienced periodic sell-offs. Such volatility can create short-term risks on financial markets. Margin calls on derivatives related to commodities can create liquidity strains for counterparties, as was witnessed by the calls for emergency liquidity assistance for energy traders and the London Metal Exchange suspending nickel trading for five trading days in early March. While commodity derivatives markets in the EU are of limited size relative to EU derivative markets as a whole, these markets create sensitive interlinkages between commodity producing or processing companies, commodity traders, banks acting as intermediaries in the clearing process, central counterparties, and other financial institutions.
The Russian invasion negatively affected credit rating agencies’ (CRA) credit outlook for EEA30 debt. The number of corporate downgrades grew relative to upgrades over 1H22, with a jump in downgrades around the time of the invasion. Russian and Ukrainian ratings were mainly affected, with a series of downgrades in late February and March among both corporates and sovereigns. By mid-April CRAs had withdrawn their Russian ratings in response to the EU measures banning the rating of Russian debt and the provision of rating services to Russian clients. In addition, sanctions have made it difficult for Russia to make sovereign coupon payments. In this context, Russia defaulted on some debt payments due in late June.
Direct impacts of the invasion on investment funds were limited. Exposures to both Russian and Ukrainian counterparties were EUR 50bn (below 0.5% of EU fund assets as of end-January 2022). Some fund exposures were higher, with 300 funds holding over 5% of their portfolios in Russian and Ukrainian assets (total EUR 225bn). The massive fall in prices and liquidity of Russian financial instruments led to serious valuation issues for exposed EU funds. In 1H22, 100 Russia-exposed EU funds (EUR 15bn in combined assets) temporarily suspended redemptions. However, funds with material Russian exposures before the invasion account for a very small share of the EU fund population (less than 0.1% of the EU industry). A number of ETFs tracking Russian benchmarks also suspended share creation. While direct impacts of the Russian invasion on funds, such as losses, were limited, existing risks were amplified by the invasion and the deteriorating macroeconomic outlook. Credit, valuation and liquidity risks remained elevated in the bond fund sector, linked to multiple factors. Bond fund exposures to credit risk stayed elevated, especially for HY funds. The credit quality of the portfolio of HY funds remained close to an average rating between BB- and B+ (5-year low). The likelihood of credit risk materialization also increased with the deteriorating macroeconomic environment and rising interest rates, as visible in the higher credit spreads. In comparison, liquidity risk remained steady for corporate bond funds. Based on asset quality and cash holdings, portfolio liquidity remained stable in 1H22.
EU insurers’ exposure to assets issued in Russia, Ukraine and Belarus is also limited. These assets amount to EUR 8.3 bn, less than 0.1% of the total investment of the sector. The exposure to Russia is EUR 6.3 bn, which is 0.066% of total investments and the asset exposure to Ukraine is EUR 1.8 bn, 0.019% of total Investments. The exposure to Belarus is negligible. Most of the investments in Russia are through investment funds (84% of total investments). Within funds, the largest asset classes are represented by sovereign bonds and equities associated to unit linked portfolios. A large share of investments to Russia, Ukraine and Belarus (42%) is in index- and unit-linked portfolios, whose risk is born directly by policyholders.
EU insurers have limited activities in the Russian, Ukrainian and Belarusian markets. A small number of EEA groups are active in those countries through subsidiaries. Their size in terms of total assets is minimal if compared to the total assets of the groups. In terms of liability portfolios exposures are also limited. Total technical provision in Russia, Ukraine and Belarus is EUR 0.36 bn., mostly concentrated in the life business.
With regards to IORPs, asset exposures are also limited, at EUR 7.5 bn. (0.23% of total investments). In absolute numbers this is similar to the exposure of the insurance sector. It is worth noting that the size of the IORPs total investment is smaller with respect to the insurance sector.
In the banking sector, direct exposure to Russia and Ukraine appears limited on an EU level and country level. In 1Q22, exposures of the EU/EEA banking sector were at EUR 75.3bn (ca. 0.3% of total assets) towards Russian counterparties, at EUR 10.0bn towards Ukrainian counterparties, and at EUR 2.0bn towards Belorussian counterparties, slightly decreasing towards the three countries compared to the previous quarter. However, exposures are concentrated in a few countries, and a few banks report an up to 10% share of their exposures towards Russia and Ukraine. Some banks also booked substantive provisions related to their exposure to Russia and related to the deteriorating economic environment in the first quarter of this year.
While immediate, first round implications from the Russian invasion appear contained for financial institutions across sectors, the possibility of second round effects is a source of concern. The invasion, heightened uncertainties and inflation are not only weighing on economic prospects, but also affect consumer- and business confidence. Exposures of economic sectors more sensitive to rising energy- and commodity prices require attention across sectors.
In the insurance sector, second-round effects could emerge via exposures to sectors which, in turn, are highly exposed to the current crisis. Losses in these sectors could have spill-over effects through losses on investments. Two areas could be the most relevant: the exposures of insurers to the banking sector and the exposure to sectors of the economy that are more sensitive to energy and gas prices. Insurers have significant holdings of bank assets, and in this context also hold a significant amount of assets issued by banks that are assumed to be more vulnerable to the evolution of the current crisis. The exposure of EEA insurers to those banks is estimated to only a total amount of EUR 55 bn (0.57% to total investments). Furthermore, insurers have significant asset exposure to sectors sensitive to energy and gas prices.6 The total exposures sum to EUR 174 bn, which includes almost 3% of the equity portfolio of insurers and 7.5% of corporate bond holdings.
In the banking sector, second-round effects could emerge via deteriorating asset quality and further increasing provisioning needs in a deteriorating economic environment. Fee and commission income might also be affected. Banks’ securities portfolios might moreover be negatively affected as fair value declines when interest rates rise. The worsening economic outlook has already resulted in slightly deteriorating early warning indicators for asset quality. The cost of risk increased to 0.51% in 1Q22, a 4bps increase compared to the previous quarter, as borrowers’ debt servicing capacity might be affected by lower economic growth. The increase was mainly driven by the numerator, i.e. by increasing allowances for credit losses. Also, the share of loans allocated under Stage 2 under IFRS increased in 1Q22 and 4Q21, and it another early-warning indicator pointing to slightly deteriorating asset quality. Responses to the EBA RAQ moreover indicate that a majority of banks expect asset quality to deteriorate.
In line with the deteriorating economic outlook and heightened market- and interest rate volatility, bank funding conditions have worsened since the Ukrainian war started and since interest rates increased. Wholesale bank debt spreads have widened for debt and capital instruments across the capital ladder, and particularly for subordinated instruments. Interest rates for bank debt instruments have risen substantially across durations, albeit from extremely low levels. Since the beginning of the war, bank debt issuance activity has been mainly focused on issuing covered bonds, amid challenging market conditions and as banks have begun to roll over expiring long-term central bank funding facilities. Bank funding conditions are likely to stay more challenging while volatility persists and as interest rates continue to rise. Yet current ample liquidity buffers should allow banks to withstand further periods of market turmoil for the time being. In the medium-term, the substitution of expiring extraordinary central bank funding with other sources of funding could prove challenging for some banks.
In spite of positive operating trends in 1Q2022, the outlook for EU bank profitability is subdued. The deteriorating economic environment might affect lending growth and might result in lower loan- and payment-related fee income. Inflationary pressure, higher provisioning needs for expected deteriorating asset quality, costs related to digital transformation and higher compliance costs, e.g. related to the enforcement of sanctions will all likely affect costs, and may offset operating cost savings achieved. While rising rates may have a positive impact on interest income, rising funding costs might also offset additional income from asset repricing.
4 INFLATION AND INTEREST RATE RISKS The Russian aggression and the sanctions applied contributed to inflation pressures via the resulting supply shocks in energy, food and metals commodities, which added to the supply chain bottlenecks related to the pandemic. Higher energy prices particularly contribute to inflation, widely increasing input and distribution costs. In terms of investment impacts, inflation directly lowers real returns. Inflation changes relative attractiveness of assets both across asset classes and within asset classes. Higher inflation reduces the values of existing assets with fixed returns, such as (most) bonds. By reducing short-term growth, higher rates lower profitability and typically reduce equity values. However, if a rate rise is expected to be effective in increasing long-term growth, it can also increase equity values. Inflation has indirect impacts through its effects on actual and anticipated monetary policy, especially interest rate rises, to reduce demand and bring inflation down. Higher interest rates increase returns on savings and raise borrowing and refinancing costs, reducing debt sustainability. Variable-rate loans face higher debt servicing costs, raising credit risk, including for securitizations backed by variable-rate loans.
In the investment fund sector, interest rate risk increased in a context of rising inflation expectations. Fund portfolios with a longer duration will see their value fall, as inflation drives rates up. However, adjustments are already being made in some funds. Bond fund portfolio durations fell in 1H22, remaining higher for Government (7.6 years, down from 8.6 years) and IG bond funds (6.5 years, down from 7.3 years) than for HY funds (4.3 years, down from 4.8 years). Based on current duration, a 100bps increase of in yield could have a potential impact of -7% on bond fund NAV, about EUR 270bn, which could lead to significant fund outflows. In the MMF sector, funds also significantly reduced the weighted average maturity of their portfolios from 44 days to 30 days (a 3-year low) to lower interest rate risk and improve resilience to a rate rise.
As a period of low inflation and low interest rate is coming to an abrupt end, medium-term risks for asset managers are considerable. Impacts on performance and fund flows are likely to vary across asset classes. For example, the recent US increase in rates led to significant reallocation across fund types from bond funds (-4.7% NAV in 1H22) towards funds offering some form of protection against higher rates. To-date, this contrasts with the EU. In 1H22, US cumulative flows into funds offering protection against higher inflation or rates, such as inflation-protected funds (EUR 1.5bn), loan funds (EUR 13.9bn) and commodity funds (EUR 16.3bn), outpaced their EU equivalents.
Inflation can have a significant impact on borrowers and retail investors. It can heighten vulnerabilities of debtors exposed to flexible lending rates, or where low interest rates on their loans will expire in the near term, including in mortgage lending. Inflation can also have large effects on real returns on savings and investments of retail investors both in the immediate term as well as in the long term. Retail investors may be unaware of inflation or not pay enough attention to its effects on their assets and purchasing power. Consumers can suffer from behavioral biases, such as money illusion or exponential growth bias, that can lead to insufficient saving and investing. Moreover, when inflation is rising, the effects of insufficient saving on long-term wealth become more pronounced.
Insurer positions are affected by inflation on both on the asset and liabilities side typically negative net effects for the non-life segment. On the asset side, insurer investments whose market prices are sensitive to inflation will see a direct or indirect impact through movements of the interest rates. On the liability side, inflation affects insurers through higher costs of claims. This is mostly relevant for non-life lines of business, because non-life guarantees are in nominal terms; crucially, insurers’ build-up provisions for future claims payments and in doing so they must make assumptions today about future price developments. Life insurers are less affected by costs of claims, these typically have liabilities in nominal terms, i.e. claims do not increase with the price development; this is because potential future benefits are often stipulated at inception. Higher general costs can have negative profitability implication for both life and non-life. Finally, the sensitivity on inflation and to interest rate depends also crucially on the duration gap of the undertakings: those with positive duration gaps are more likely to be negatively affected by inflation than those with negative long duration gap, such as life insurers.
On the liability side, the price development relevant for claims expenses, i.e. claims inflation, is particularly important for insurers. Claims inflation tends to outpace the general inflation rate, claims cost depends only to a small extent on inflation as measured by the Harmonized Index of Consumer Prices (HICP); the reason is that the goods for which insurers pay are significantly different from those which consumers buy. Moreover, claims of insurers encompass various costs, not just costs of goods and services. For Europe, there are no time series available on estimates of future claims inflation; each insurer makes its own business line specific forecast.
Developments in the term structure and risk premia, which remain uncertain, are also having an impact on the net effect on insurer positions, through their exposure to interest rate sensitive assets and the duration of their liabilities. A potential increase in long-term rates would be accompanied by a repricing of the risk premia, and the negative impact on the asset side would not be limited to the fixed income assets but would be reflected to other asset classes through the reduction of market prices. A similar scenario was tested in the EIOPA 2018 Stress Test exercise (Yield Curve Up scenario). This showed relatively high resilience of the insurance sector as a result of the solid capital buffers of the sector in aggregate.
Insurance products can be sensitive to inflation, policyholders and pension beneficiaries face the risk of inflation eroding the real value of their benefits. This ultimately depends on the particular features and details of each contract sold. In the traditional business case of nominal interest rate guarantees, higher inflation than expected (relative to that already factored in the guarantees) has a negative impact in real terms for the policyholder, while contracts with profit sharing may help policyholder returns. In case of unit-linked policies, the policyholder can select the underlying assets from a range of investments e.g. mutual funds. The allocation could involve assets that provide inflation protection or not. Crucially, it requires policyholder financial knowledge/literacy to navigate through the complex dynamics of how investments affect their benefits. In the last years, the share of unit-linked in the life segment continues to increase, now reaching a peak of 39% since the introduction of Solvency II reporting, notwithstanding the considerable differences in the popularity of unit-linked products that remain across countries.
In the banking sector, increasing interest rates are usually expected to have a positive impact on interest income and on net interest margins (NIMs). Accordingly, a vast majority of banks responding to the spring 2022 EBA RAQ expect a positive impact on their profitability from rising interest rates with a repricing of assets. Both banks and analysts are optimistic about the impact of rising rates, and 85% of banks responding to the RAQ expect rising rates to have a positive impact on their profitability. However, analysts also expect an increase in provisions and impairments (at 80%, compared to 15% in the previous RAQ). Since 2014 NIMs have steadily decreased in the very low interest rate environment, and have remained nearly stable since Q1 2021 (1.25% in Q2 2022).
In spite of positive expectations, historic episodes of rising interest rates globally, as well as bank profitability trends in some European countries with an earlier cycle of increasing interest rates offer some indication that NIM may not improve substantially with rising interest rates. Expectations for a substantively positive impact on profitability may be overly optimistic. For example, during periods of stagflation in the USA between 1971 and 1973 and between 1976 and 1980, the sensitivity of NIM to interest rate rises was negligible. Disclosures from banks’ interest rate risks in the banking book (IRRBB) indicate that a parallel shift up of the yield curve positively affects NII for most banks. Yet, while about half of banks disclosing their IRRBB assume that a 200bp parallel rise of the yield curve will add at least a 10% to their NII, a majority of banks assume a negative net impact on their economic value of equity (EVE), a long-term measure of their interest rate risk.
On the liabilities’ side, bank funding costs have increased considerably in line with rising interest rates, which affects profitability. In the next months, analysts expect a broad-based increase in funding costs, including for deposits. Banks, particularly those relying more on wholesale funding, may be affected by a potential substantial increase in funding costs that could even offset positive effects from asset repricing. Banks that need to further build up their loss absorbing capacity could be particularly affected, as a majority of banks consider pricing as main constraint to issuing instruments eligible for MREL. In line with rising inflation, EU banks’ operating costs are also expected to increase further and have already increased substantially in 1Q22.
While general expectations suggest that banks will benefit from a repricing of assets amid rising interest rates, increasing rates might also affect borrower ability to service their debt, and could thus affect asset quality. Coupled with a deteriorating economic outlook, the rising interest rate environment risks in resulting in a reversal of the long-term trend of declining NPL in the banking sector. Rising rates could also contribute to adjustments to the already high real estate valuations in Europe, while the high levels of real estate exposure of EU banks has been identified as a risk. Monetary tightening might also impact lending growth, when, e.g., tightening is accompanied by lower GDP growth, and so could affect interest income.
5 DIGITAL RELATED RISKS The Russian war in Ukraine and the increasingly volatile geopolitical environment have heightened cybersecurity risks. The frequency of cyber incidents impacting all sectors of activity, as measured by publicly available data, increased significantly in the first quarter of 2022 compared to the same quarter of last year. The potential for escalation involving cyberattacks remains, and a successful attack on a major financial institution or on a critical infrastructure could spread across the entire financial system. Potential consequences also grow ever more far-reaching as the digitalization trend of the financial sector continues. These include disruptions to business continuity, as well as impact on reputation and, in extreme scenarios, liquidity and financial stability. Potential cyberattacks might not be limited to the financial sector only, but also to consumers. In a severe scenario, access to basic services could be impaired, including financial services, and personal data could be compromised.
The sharp market sell-off in May and June 2022 once again demonstrated the extremely volatile and speculative nature of many crypto-assets and related products and the high risks involved for investors, as highlighted in the recent joint-ESAs Warning. The collapse of the Terra ecosystem in May exposed fragilities in stable coins markets, which if left unmanaged, could have ripple effects with negative implications for financial stability, calling for a swift implementation of the Markets in Crypto Assets (MiCA) proposed regulation.
The current geopolitical situation underscores the relevance of the legislation on digital operational resilience (DORA). DORA, which builds on the ESAs Joint Advice in the area of information and communication technology (ICT), is expected to enter into force in early 2023. On 10 May 2022 co-legislators reached a provisional political agreement on its final text. DORA aims to establish a comprehensive framework on digital operational resilience for EU financial entities, and consolidate and upgrade ICT risk requirements spread over various financial services legislation (e.g. PSD2, MiFID, NIS). The geopolitical situation has highlighted some of the risks that DORA will address and underscores the importance of the legislation. The ESAs will be working closely together on the many joint deliverables and new tasks under DORA to help implement the legislation. Moreover, the ESAs, in cooperation with NCAs, have launched a high-level exercise (covering a sample of financial entities) to obtain a better understanding of the exposure of the financial sector to ICT third party providers. The exercise will help authorities and entities to prepare for the forthcoming DORA regime for oversight of critical third-party providers of ICT services.
Digitalization and cyber risks are currently assessed as high and show an increasing trend for the financial sector. In the banking sector, cyber risks are assessed to be very high by both banks and supervisors. The insurance, banking and markets sectors likewise remain on high alert. Since the beginning of the war, cyber-related incidents and disruptions beyond Ukraine and Russia have been rather limited to date, but related risks nevertheless remain unabatedly high. Cyber negative sentiment in the insurance sector, measured as the frequency of negative cyber terms pronounced during insurers’ earning calls, indicates an increased concern in the first quarter of 2022. From an insurance cyber underwriting perspective, cyber-related claims are increasing alongside a growth in the frequency and sophistication of cyber-attacks across financial sectors. In response to increasing cyber-attacks, cyber insurers are strengthening the wording to protect them against losses and could eventually also adjust pricing. Insurers seem to have pushed up attempts to tighten policies and to clarify coverage in the case of a retaliation by Russia and its allies in response to sanctions – the so-called war exclusion, which dictates that losses caused by armed conflict are usually not compensated. In this context, clear communication and disclosure to policyholders on the scope of the coverage and level of protection offered by insurance policies is crucial, in order to avoid a mismatch between their expectations and the actual coverage provided.
Supervisors aim at enhancing monitoring of cyber-related risk framework due to the increased relevance of digitalization and cyber risks. ESMA has recently facilitated increased information-sharing among its competent authorities to ensure supervisors receive timely updates on cyber incidents to inform their work. Turning to the insurance sector, EIOPA has produced exploratory indicators that rely on supervisor responses to the EIOPA Insurance Bottom-Up Survey and on publicly available external data. They will be improved once new supervisory data becomes available. To establish an adequate assessment and mitigation tools to address potential systemic cyber and extreme risks, throughout 2022 and 2023 EIOPA will be working on improving its methodological framework for bottom-up insurance stress tests, including cyber risk.
During the 2020 review of Solvency II EIOPA identified several divergent practices regarding the valuation of best estimate, as presented in the analysis background document to EIOPA’s Opinion on the 2020 review of Solvency II. Divergent practices require additional guidance to ensure a convergent application of the existing regulation on best estimate valuation.
In accordance with Article 16 of Regulation (EU) No 1094/20102 EIOPA issues these revised Guidelines to provide guidance on how insurance and reinsurance undertakings should apply the requirements of Directive 2009/138/EC3 (“Solvency II Directive”) and in Commission Delegated Regulation (EU) No 2015/354 (“Delegated Regulation”), on best estimate valuation.
This revision introduces new Guidelines and amends current Guidelines on topics that are relevant for the valuation of best estimate, including
the use of future management actions and expert judgment,
the modelling of expenses and the valuation of options and guarantees by economic scenarios generators
and modelling of policyholder behaviour.
EIOPA also identified the need for clarification in the calculation of expected profits in future premiums (EPIFP).
The revised Guidelines apply to both individual undertakings and mutatis mutandis at the level of the group. These revised Guidelines should be read in conjunction with and without prejudice to the Solvency II Directive, the Delegated Regulation and EIOPA’s Guidelines on the valuation of technical provisions. Unless otherwise stated in this document, the current guidelines of EIOPA’s Guidelines on the valuation of technical provisions remain unchanged and continue to be applicable.
If not defined in these revised Guidelines, the terms have the meaning defined in the Solvency II Directive. These revised Guidelines shall apply from 01-01-2023.
NEW: GUIDELINE 0 – PROPORTIONALITY 3.1. Insurance and reinsurance undertakings should apply the Guidelines on valuation of technical provisions in a manner that is proportionate to the nature, scale and complexity of the risks inherent in their business. This should not result in a material deviation of the value of the technical provisions from the current amount that insurance and reinsurance undertakings would have to pay if they were to transfer their insurance and reinsurance obligations immediately to another insurance or reinsurance undertaking.
NEW: GUIDELINE 24A – MATERIALITY IN ASSUMPTIONS SETTING 3.6. Insurance and reinsurance undertakings should set assumptions and use expert judgment, in particular taking into account the materiality of the impact of the use of assumptions with respect to the following Guidelines on assumption setting and expert judgement. 3.7. Insurance and reinsurance undertakings should assess materiality taking into account both quantitative and qualitative indicators and taking into consideration binary events, extreme events, and events that are not present in historical data. Insurance and reinsurance undertakings should overall evaluate the indicators considered.
NEW: GUIDELINE 24B – GOVERNANCE OF ASSUMPTIONS SETTING 3.11. Insurance and reinsurance undertakings should ensure that all assumption setting and the use of expert judgement in particular, follows a validated and documented process. 3.12. Insurance and reinsurance undertakings should ensure that the assumptions are derived and used consistently over time and across the insurance or reinsurance undertaking and that they are fit for their intended use. 3.13. Insurance and reinsurance undertakings should approve the assumptions at levels of sufficient seniority according to their materiality, for most material assumptions up to and including the administrative, management or supervisory body.
NEW: GUIDELINE 24C – COMMUNICATION AND UNCERTAINTY IN ASSUMPTIONS SETTING 3.14. Insurance and reinsurance undertakings should ensure that the processes around assumptions, and in particular around the use of expert judgement in choosing those assumptions, specifically attempt to mitigate the risk of misunderstanding or miscommunication between all different roles related to such assumptions. 3.15. Insurance and reinsurance undertakings should establish a formal and documented feedback process between the providers and the users of material expert judgement and of the resulting assumptions. 3.16. Insurance and reinsurance undertakings should make transparent the uncertainty of the assumptions as well as the associated variation in final results.
NEW: GUIDELINE 24D – DOCUMENTATION OF ASSUMPTIONS SETTING 3.17. Insurance and reinsurance undertakings should document the assumption setting process and, in particular, the use of expert judgement, in such a manner that the process is transparent. 3.18. Insurance and reinsurance undertakings should include in the documentation
the resulting assumptions and their materiality,
the experts involved,
the intended use
and the period of validity.
3.19. Insurance and reinsurance undertakings should include the rationale for the opinion, including the information basis used, with the level of detail necessary to make transparent both the assumptions and the process and decision-making criteria used for the selection of the assumptions and disregarding other alternatives. 3.20. Insurance and reinsurance undertakings should make sure that users of material assumptions receive clear and comprehensive written information about those assumptions.
NEW: GUIDELINE 24E – VALIDATION OF ASSUMPTIONS SETTING 3.21. Insurance and reinsurance undertakings should ensure that the process for choosing assumptions and using expert judgement is validated. 3.22. Insurance and reinsurance undertakings should ensure that the process and the tools for validating the assumptions and in particular the use of expert judgement are documented. 3.23. Insurance and reinsurance undertakings should track the changes of material assumptions in response to new information, and analyse and explain those changes as well as deviations of realisations from material assumptions. 3.24. Insurance and reinsurance undertakings, where feasible and appropriate, should use validation tools such as stress testing or sensitivity testing. 3.25. Insurance and reinsurance undertakings should review the assumptions chosen, relying on independent internal or external expertise. 3.26. Insurance and reinsurance undertakings should detect the occurrence of circumstances under which the assumptions would be considered false.
AMENDED: GUIDELINE 25 – MODELLING BIOMETRIC RISK FACTORS 3.27. Insurance and reinsurance undertakings should consider whether a deterministic or a stochastic approach is proportionate to model the uncertainty of biometric risk factors. 3.28. Insurance and reinsurance undertakings should take into account the duration of the liabilities when assessing whether a method that neglects expected future changes in biometrical risk factors is proportionate, in particular in assessing the error introduced in the result by the method. 3.29. Insurance and reinsurance undertakings should ensure, when assessing whether a method that assumes that biometric risk factors are independent from any other variable is proportionate, and that the specificities of the risk factors are taken into account. For this purpose, the assessment of the level of correlation should be based on historical data and expert judgment.
NEW: GUIDELINE 28A – INVESTMENT MANAGEMENT EXPENSES 3.30. Insurance and reinsurance undertakings should include in the best estimate administrative and trading expenses associated with the investments needed to service insurance and reinsurance contracts. 3.31. In particular, for products whose terms and conditions of the contract or the regulation requires to identify the investments associated with a product (e.g. most unit linked and index linked products, products managed in ring-fenced funds and products to which matching adjustment is applied), insurance and reinsurance undertakings should consider the investments. 3.32. For other products, insurance and reinsurance undertakings should base the assessment on the characteristics of the contracts. 3.33. As a simplification, insurance and reinsurance undertakings may also consider all investment management expenses. 3.34. Reimbursements of investment management expenses that the fund manager pays to the undertaking should be taken into account as other incoming cash flows. Where these reimbursements are shared with the policyholders or other third parties, the corresponding cash out flows should also be considered.
AMENDED: GUIDELINE 30 – APORTIONMENT OF EXPENSES 3.41. Insurance and reinsurance undertakings should allocate and project expenses in a realistic and objective manner and should base the allocation of these expenses
on their long-term business strategies,
on recent analyses of the operations of the business,
on the identification of appropriate expense drivers
and on relevant expense apportionment ratios.
3.42. Without prejudice to the proportionality assessment and the first paragraph of this guideline, insurance and reinsurance undertakings should consider using, in order to allocate overhead expenses over time, the simplification outlined in Technical Annex I, when the following conditions are met:
a) the undertaking pursues annually renewable business; b) the renewals must be reputed to be new business according the boundaries of the insurance contract; c) the claims occur uniformly during the coverage period.
AMENDED: GUIDELINE 33 – CHANGES IN EXPENSES 3.47. Insurance and reinsurance undertakings should ensure that assumptions with respect to the evolution of expenses over time, including future expenses arising from commitments made on or prior to the valuation date, are appropriate and consider the nature of the expenses involved. Insurance and reinsurance undertakings should make an allowance for inflation that is consistent with the economic assumptions made and with dependency of expenses on other cash flows of the contract.
NEW: GUIDELINE 37A – DYNAMIC POLICYHOLDER BEHAVIOUR 3.53. Insurance and reinsurance undertakings should base their assumptions on the exercise rate of relevant options on:
statistical and empirical evidence, where it is representative of future conduct, and
expert judgment on sound rationale and with clear documentation.
3.54. The lack of data for extreme scenarios should not be considered alone to be a reason to avoid dynamic policyholder behaviour modelling and/or the interaction with future management actions.
NEW: GUIDELINE 37B – BIDIRECTIONAL ASSUMPTIONS 3.59. When setting the assumptions on dynamic policyholder behaviour, insurance and reinsurance undertakings should consider that the dependency on the trigger event and the exercise rate of the option is usually bidirectional, i.e. both an increase and a decrease should be considered depending on the direction of the trigger event.
NEW: GUIDELINE 37C – OPTION TO PAY ADDITIONAL OR DIFFERENT PREMIUMS 3.60. Insurance and reinsurance undertakings should model all relevant contractual options when projecting the cash flows, including the option to pay additional premiums or to vary the amount of premiums to be paid that fall within contract boundaries.
NEW: GUIDELINE 40A – COMPREHENSIVE MANAGEMENT PLAN 3.61. Insurance and reinsurance undertakings should ensure that the comprehensive future management actions plan that is approved by the administrative, management or supervisory body is either:
a single document listing all assumptions relating to future management actions used in the best estimate calculation; or
a set of documents, accompanied by an inventory, that clearly provide a complete view of all assumptions relating to future management actions used in best estimate calculation.
NEW: GUIDELINE 40B – CONSIDERATION OF NEW BUSINESS IN SETTING FUTURE MANAGEMENT ACTIONS 3.64. Insurance and reinsurance undertakings should consider the effect of new business in setting future management actions and duly consider the consequences on other related assumptions. In particular, the fact that the set of cash-flows to be projected through the application of Article 18 of the Delegated Regulation on contract boundaries is limited should not lead insurance and reinsurance undertakings to consider that assumptions only rely on this projected set of cash-flows without any influence of new business. This is particularly the case for assumptions on the allocation of risky assets, management of the duration gap or application of profit sharing mechanisms.
NEW: GUIDELINE 53A – USE OF STOCHASTIC VALUATION 3.70. Insurance and reinsurance undertakings should use stochastic modelling for the valuation of technical provisions of contracts whose cash flows depend on future events and developments, in particular those with material options and guarantees. 3.71. When assessing whether stochastic modelling is needed to adequately capture the value of options and guarantees, insurance and reinsurance undertakings should, in particular but not only, consider the following cases:
any kind of profit-sharing mechanism where the future benefits depend on the return of the assets;
financial guarantees (e.g. technical rates, even without profit sharing mechanism), in particular, but not only, where combined with options (e.g. surrender options) whose dynamic modelling would increase the present value of cash flows in some scenarios.
NEW: GUIDELINE 57A – MARKET RISK FACTORS NEEDED TO DELIVER APPROPRIATE RESULTS 3.75. When assessing whether all the relevant risk factors are modelled with respect to the provisions of Articles 22(3) and 34(5) of the Delegated Regulation, insurance and reinsurance undertakings should be able to demonstrate that their modelling adequately reflects the volatility of their assets and that the material sources of volatility are appropriately reflected (e.g. spreads and default risk). 3.76. In particular, insurance and reinsurance undertakings should use models that allow for the modelling of negative interest rates.
AMENDED: GUIDELINE 77 – ASSUMPTIONS USED TO CALCULATE EPIFP 3.78. For the purpose of calculating the technical provisions without risk margin under the assumption that the premiums relating to existing insurance and reinsurance contracts that are expected to be received in the future are not received, insurance and reinsurance undertakings should apply the same actuarial method used to calculate the technical provisions without risk margin in accordance with Article 77 of the Solvency II Directive, with the following changed assumptions:
a) policies should be treated as though they continue to be in force rather than being considered as surrendered; b) regardless of the legal or contractual terms applicable to the contract, the calculation should not include penalties, reductions or any other type of adjustment to the theoretical actuarial valuation of technical provisions without a risk margin calculated as though the policy continued to be in force.
3.79. All the other assumptions (e.g. mortality, lapses or expenses) should remain unchanged. This means that the insurance and reinsurance undertakings should apply
the same projection horizon,
future management actions
and policyholder option exercise rates used in best estimate calculation
without adjusting them to consider that future premiums will not be received. Even if all assumptions on expenses should remain constant, the level of some expenses (e.g. acquisition expenses or investment management expenses) could be indirectly affected.
NEW: GUIDELINE 77A – ALTERNATIVE APPROACH TO CALCULATE EPIFP 3.88. Insurance and reinsurance undertakings may identify EPIFP as the part of present value of future profits related to future premiums in case the outcome does not materially deviate from the value that would have resulted from the valuation described in Guideline 77. This approach may be implemented using a formula design.
EIOPA’S DIGITAL TRANSFORMATION STRATEGIC PRIORITIES AND OBJECTIVES
EIOPA’s supervisory and regulatory activities are always underpinned by two overarching objectives: promoting consumer protection and financial stability. The digital transformation strategy aims at identifying areas where, in view of these overarching objectives, EIOPA can best commit its resources in view of the challenges posed by digitalisation, while at the same time seeking to identify and remove undue barriers that limit the benefits.
This strategy sits alongside EIOPA’s other forward thinking prioritisation tools –
the union-wide strategic supervisory priorities,
the Strategy on Cyber Underwriting,
the Suptech Strategy
– but its focus is less on the specific actions needed in different areas, and more on how EIOPA will support NCAs and the pensions and insurance sectors in facing digital transformations following a
technologically-neutral,
future-proof,
ethical
and secure approach
to financial innovation and digitalisation.
Five key long-term priorities have been identified, which will guide EIOPA’s contributions on digitalisation topics:
Leveraging on the development of a sound European data ecosystem
Preparing for an increase of Artificial Intelligence while focusing on financial inclusion
Ensuring a forward looking approach to financial stability and resilience
Realising the benefits of the European single market
Enhancing the supervisory capabilities of EIOPA and NCAs.
These five long-term priorities are described in the following sections. Each relates to areas where work is already underway or planned, whether at national or European level, by EIOPA or other European bodies.
The aim is to focus on priority areas where EIOPA can add value so as to enhance synergies and improve overall convergence and efficiency in our response as a supervisory community to the digital transformation.
LEVERAGING ON THE DEVELOPMENT OF A SOUND EUROPEAN DATA ECO-SYSTEM ACCOMPANYING THE DEVELOPMENT OF AN OPEN FINANCE AND OPEN INSURANCE FRAMEWORK Trends in the market show that the exchange of both personal and non-personal data through Application Programming Interfaces (APIs) is a leading factor leading to transformation and integration in the financial sector. By enabling several stakeholders to “plug” to an API to have access to timely and standardised data, insurance undertakings in collaboration with other service providers can timely and adequately assess the needs of consumers and develop innovative and convenient proposals for them. Indeed, there are multiple types of use cases that can be developed as a result of enhanced accessing and sharing of data in insurance.
Examples of potential use cases include pension tracking systems (see further below), public and private comparison websites, or different forms of embedding insurance (including micro insurances) in the channels of other actors (retailers, airlines, car sharing applications, etc.).
Another use case could consist in allowing consumers to conveniently access information about their insurance products from different providers in an integrated platform / application and identify any protection gaps (or overlaps) in coverage that they may have.
In addition to having access to a greater variety of products and services and enabling consumers to make more informed decisions, the transfer of insurance-related data seamlessly from one provider to another in real-time (data portability) could facilitate switching and enhance competition in the market.
Supervisory authorities could also potentially connect into the relevant APIs to access anonymised market data so as to develop more pre-emptive and evidence-based supervision and regulation.
However, it is also important to take into account relevant risks such those linked to data
quality,
breaches
and misuse.
ICT/cyber risks and financial inclusion risks are also relevant, as well as issues related to a level playing field and data reciprocity.
EIOPA considers that, if the risks are handled right, several open insurance use cases can have significant benefits for consumers, for the sector and its supervision and will use the findings of its recent public consultation on this topic to collaborate with the European Commission on the development of the financial data space and/or open finance initiatives respectively foreseen in the Commission’s Data Strategy and Digital Finance Strategy, possibly focusing on specific use cases.
ADVISING ON THE DEVELOPMENT OF PENSIONS DATA TRACKING SYSTEMS IN THE EU European public pension systems are facing the dual challenge of remaining financially sustainable in an aging society and being able to provide Europeans with an adequate income in retirement. Hence, the relevance of supplementary occupational and personal pension systems is increasing. The latter are also seeing a major trend influenced by the low interest environment consisting on the shift from Defined Benefit (DB) plans, which guarantee citizens a certain income after retirement, to Defined Contribution (DC) plans, where retirement income depends on how the accumulated contributions have been invested. As a consequence of these developments, more responsibility and financial risks are placed on individual citizens for planning for their income after retirement.
In this context, Pensions Tracking Systems (PTS) can provide simple and understandable information to the average citizen about his or her pension savings in an aggregated manner, typically conveniently accessible via digital channels. PTS are linked to the concept of Open Finance, since different providers of statutory and private pensions share pension data in a standardised manner so that it can be aggregated so as to provide consumers with relevant information for adopting informed decisions about their retirement planning.
EIOPA considers that it is increasingly important to provide consumers with adequate information to make informed decisions about their retirement planning, as it is reflected in EIOPA’s technical advice to the European Commission on best practices for the development of Pension Tracking Systems. EIOPA remains ready to further assist on this area, as relevant.
TRANSITIONING TOWARDS A SUSTAINABLE ECONOMY WITH THE HELP OF DATA AND TECHNOLOGY Technologies such as
AI,
Blockchain,
or the Internet of Things
can assist European insurance undertakings and pension schemes in the implementation of more sustainable business models and investments.
For example, greater insights provided by new datasets (e.g. satellite images or images taken by drones) combined with more granular AI systems may allow to better assess climate change-related risks and provide advanced insurance coverage. Indeed, as highlighted by the Commission’s strategy on adaptation to climate change, actions aimed to adapt to climate change should be informed by more and better data on climate-related risks and losses accessible to everyone as well as relevant risks assessment tools.
This would allow insurance undertakings to contribute to a wider inclusion by incentivising customers to mitigate risks via policies whose pricing and contractual terms are based on effective measurements, e.g. with the use of telematics-based solutions in home insurance. However, there are also concerns about the impact on the affordability and availability of insurance for certain consumers (e.g. consumers living in areas highly exposed to flooding) as well as regarding the environmental impact of some technologies, notably concerning the energy consumption of certain data centres and crypto-assets.
Promoting a sustainable economy is a core priority for EIOPA. For this purpose, EIOPA will specifically develop a Sustainable Finance Action Plan highlighting, among other things, the importance of improving the accessibility and availability of data and models on climate-related risks and insured losses and the role that EIOPA can play therein, as highlighted by the Commission’s strategy on adaptation to climate change and in line with the Green deal data space foreseen in the Commission’s Data Strategy.
PREPARING FOR AN INCREASE OF ARTIFICIAL INTELLIGENCE WHILE FOCUSING ON FINANCIAL INCLUSION TOWARDS AN ETHICAL AND TRUSWORTHY ARTIFICIAL INTELLIGENCE IN THE EUROPEAN INSURANCE SECTOR The take-up of AI in all the areas of the insurance value chain raises specific opportunities and challenges; the variety of use cases is fast moving, while the technical, ethical and supervisory issues thrown up in ensuring appropriate governance, oversight, and transparency are wide ranging. Indeed, while the benefits of AI in terms of prediction accuracy, cost efficiency and automation are very relevant, the challenges raised by
the limited explainability of some AI systems
and the potential impact on some AI use cases on the fair treatment of consumers and the financial inclusion of vulnerable consumers and protected classes
is also significant.
A coordinated and coherent approach across markets, insurance undertakings and intermediaries, and between supervisors is therefore of particular importance, also given the potential costs of addressing divergences in the future. EIOPA acknowledges that AI can play a pivotal role in the digital transformation of the insurance and pension markets in the years to come and therefore the importance of establishing adequate governance frameworks to ensure ethical and trustworthy AI systems. EIOPA will seek to leverage the AI governance principles recently developed by its consultative expert group on digital ethics, to develop further sectorial work on specific AI use cases in insurance.
PROMOTING FINANCIAL INCLUSION IN THE DIGITAL AGE On the one hand, new technologies and business models could be used to improve the financial inclusion of European citizens. For example, young drivers using telematics devices installed in their cars or diabetes patients using health wearable devices reportedly have access to more affordable insurance products. In addition to the incentives arising from advanced risk-based pricing, insurance undertakings could provide consumers loss prevention / risk mitigation services (e.g. suggestions to drive safely or to adopt healthier lifestyles) to help them understand and mitigate their risk exposure.
From a different perspective, digital communication channels, new identity solutions and onboarding options could also facilitate access to insurance to certain customer segments. On the other hand, certain categories of consumers or consumers not willing to share personal data could encounter difficulties in accessing affordable insurance as a result of more granular risk assessments. This would be for instance the case of consumers having difficulties to access affordable flood insurance as a result detailed risk-based pricing enabled by satellite imagery processed by AI systems. In addition,
other groups of potentially vulnerable consumers deserve special attention due to their personal characteristics (e.g. elderly people or in poverty),
life-time events (e.g. car accident),
health conditions (e.g. undergoing therapy)
or people with difficulties to access digital services.
Furthermore, the trend towards increasingly data-driven business models can be compromised if adequate governance measures are not put in place to deal with biases in datasets used in order to avoid discriminatory outcomes.
EIOPA will assess the topic of financial inclusion from a broader perspective i.e. not only from a digitalisation angle, seeking to promote the fair and ethical treatment of consumers, in particular in front-desk applications and in insurance lines of businesses that are particularly important due to their social impact.
EIOPA will routinely assess its consumer protection supervisory and policy work in view of impacts on financial inclusion, and ensuring its work on digitalisation takes into account accessibility or inclusion impacts.
ENSURING A FORWARD LOOKING APPROACH TO FINANCIAL STABILITY AND RESILIENCE ENSURING A RESILIENT AND SECURE DIGITALISATION Similar to other sectors of the economy, incumbent undertakings as well as InsurTech start-ups increasingly rely on information and communication technology (ICT) systems in the provision of insurance and pensions services. Among other benefits, the increasing adoption of innovative ICT allow undertakings to implement more efficient processes and reduce operational costs, enable data tracking and data backups in case of incidents, as well as greater accessibility and collaboration within the organisation (e.g. via cloud computing systems).
However, undertakings’ operations are also increasingly vulnerable to ICT security incidents, including cyberattacks. Furthermore, the complexity of some ICT or a different governance applied to new technologies (e.g. cloud computing) is increasing as well as the frequency of ICT related incidents (e.g. cyber incidents), which can have a considerable impact on undertakings’ operational functioning. Moreover, relevance of larger ICT service providers could also lead to concentration and contagion risks. Supervisory authorities need to take into account these developments and adapt their supervisory skills and competences accordingly.
Early on, EIOPA identified cyber security and ICT resilience as a key policy priority and in the years to come will focus on the implementation of those priorities, including the recently adopted cloud computing and ICT guidelines, and on the upcoming implementation of the Digital Operational Resilience Act (DORA).
ASSESSING THE PRUDENTIAL FRAMEWORK IN THE LIGHT OF DIGITALISATION The Solvency II Directive sets out requirements applicable to insurance and reinsurance undertakings in the EU with the aim to ensure their financial soundness and provide adequate protection to policyholders and beneficiaries. The Solvency II Directive follows a proportional, risk-based and technology-neutral approach and therefore it remains fully relevant in the context of digitalisation. Under this approach, all undertakings, including start-ups that wish to obtain a licence to benefit from Solvency II’s pass-porting rights to access the Internal Market via digital (and non-digital) distribution channels need to meet the requirements foreseen in the Directive, including minimal capital.
A prudential evaluation respective digital transformation processes should consider that insurance undertakings are incurring in high IT-related costs, to be appropriately reflected in their balance sheet. Furthermore, Solvency II requirement on outsourcing and the system of governance requirements are also relevant, in light of the increasing collaboration with third-party service providers (including BigTechs) and the use of new technologies such as AI. Investments on novel assets such as crypto-assets as well as the trend towards the “platformisation” of the economy are also relevant from a prudential perspective and the type of activities developed by insurance undertakings.
EIOPA considers that it is important to assess the prudential framework in light of the digital transformation that is taking place in the sector, seeking to ensure its financial soundness, promote greater supervisory convergence and also assess whether digital activities and related risks are adequately captured and if there are any undue regulatory barriers to digitalisation in this area.
REALISING THE BENEFITS OF THE EUROPEAN SINGLE MARKET SUPPORTING THE DIGITAL SINGLE MARKET FOR INSURANCE AND PENSION PRODUCTS Digital distribution can readily cross borders and reduce linguistic and other barriers; economies of scale linked to offering products to a wider market, increased competition, and greater variety of products and services for consumers are some of the benefits arising from the European Internal Market.
However, the scaling up the scope and speed of distribution of products and services across the Internal Market is an area where there is still a major untapped potential. Indeed, while legislative initiatives such as the
Insurance Distribution Directive (IDD),
Solvency II Directive,
Packaged Retail and Insurance-based Investment Products (PRIIPs) Regulation,
or the Directive on the activities and supervision of institutions for occupational retirement provision (IORP II)16
have made considerable progress towards the convergence of national regimes in Europe, considerable supervisory and regulatory divergences still persist amongst EU Member States.
For example, the IDD is a minimum harmonisation Directive. Existing regulation does not always allows for a fully digital approach. For instance, the need to use non-digital signatures or paper-based requirements as established by Article 23 (1) (a) IDD and Article 14 (2) (a) PRIIPs Regulation can limit end-to-end digital workflows. It is critical that the opportunities – and risks, for instance in relation to financial inclusion and accessibility – that come with digital transformations are fully integrated into future policy work. In this context, the so-called 28th regime used in Regulation on a pan-European Personal Pension Product (PEPP)17, which does not replace or harmonise national systems but coexists with them, is an approach that could eventually be explored taking into account the lessons learned.
EIOPA supports the development of the Internal Market in times of transformation, through the recalibration where needed of the IDD, Solvency II, PRIIPS and IORP II from a digital single market perspective. EIOPA will also explore what a digital single market for insurance might look like from a regulatory and supervisory perspective. Furthermore, EIOPA will integrate a digital ‘sense check’ into all of its policy work, where relevant.
SUPPORTING INNOVATION FACILITATORS IN EUROPE In recent years many NCAsin the EU have adopted initiatives to facilitate financial innovation. These initiatives include the establishment of innovation facilitators such as ‘innovation hubs’ and ‘regulatory sandboxes’ to exchange views and experience concerning Fintech-related regulatory issues and enable the testing and development of innovative solutions in a controlled environment and to learn more as to supervisory expectations. These initiatives also allow supervisory authorities to gather a better understanding of the new technologies and business models taking place in the market.
At European level, the European Forum for Innovation Facilitators (EFIF), created in 2019, has become an important forum where European supervisors share experiences from their national innovation facilitators and discuss with stakeholders topics such as Artificial Intelligence, Platformisation, RegTech or crypto-assets. The EFIF will soon be complemented with the Commission’s Digital Finance platform; a new digital interface where stakeholders of the digital finance ecosystem will be able to interact.
Innovation facilitators can play a key role in the implementation and adoption of innovative technologies and business models in Europe and EIOPA will continue to support them through its work in the EFIF and the upcoming Digital Finance Platform. EIOPA will work to further facilitate cross-border / cross-sector cooperation and information exchanges on emergent business models.
ADDRESSING THE OPPORTUNITIES AND CHALLENGES OF FRAGMENTED VALUE CHAINS AND THE PLATFORM ECONOMY New actors including InsurTech start-ups and BigTech companies are entering the insurance market, both as competitors as well as cooperation partners of incumbent insurance undertakings.
Concerning the latter, incumbent undertakings reportedly increasingly revert to third-party service providers to gain quick and efficient access to new technologies and business models. For example, based on in EIOPA’s Big Data Analytics thematic review, while the majority of the participating insurance undertakings using BDA solutions in the area of claims management developed these tools in-house, two thirds of the undertakings reverted to outsourcing arrangements in order to implement AI-powered chatbots.
This trend is reinforced by the platformisation of the economy, which in the insurance sector goes beyond traditional comparison websites and is reflected in the development of complex ecosystems integrating different stakeholders. They often share data via Application Programming Interfaces (APIs) and cooperate in the distribution of insurance products via platforms (including those of BigTechs) embedded (bundled) with other financial and non-financial services. In addition, in a broader context of Decentralised Finance (DEFI), Peer-to-Peer (P2P) insurance business models using digital platforms and different levels of decentralisation to interact with members with similar risks profiles have also emerged in several jurisdiction; although their significance in terms of gross written premiums is very limited to date, it is a matter that needs to be monitored.
EIOPA notes the opportunities and challenges arising from increasingly fragmented value chains and the platformisation of economy which will be reflected in the ESAs upcoming technical advice on digital finance to the European Commission, and will subsequently support any measures within its remit that may be needed to
encourage innovation and competition,
protect consumers,
safeguard financial stability
and ensure a level playing field.
ENHANCING THE SUPERVISORY CAPABILITIES OF EIOPA AND NCAS LEVERAGING ON TECHNOLOGY AND DATA FOR MORE EFFICIENT SUPERVISION AND REGULATORY COMPLIANCE Digital technologies can also help supervisors to implement more agile and efficient supervisory processes (commonly known as Suptech). They can support a continuous improvement of internal processes as well as business intelligence capabilities, including enhancing the analytical framework, the development of risk assessments and the publication of statistics. This can also include new capabilities for identifying and assessing conduct risks.
With its European perspective, EIOPA can play a key role by enhancing NCAs data analysis capabilities based on extensive and rich datasets and appropriate processing tools.
As outlined in its SupTech strategy and Data and IT strategy, EIOPA has the objective to promote its own transformation to become a digital, user-focused and data driven organisation that meets its strategic objectives effectively and efficiently. Several on-going projects are already in place to achieve this objective.
INCREASING THE UNDERSTANDING OF NEW TECHNOLOGIES BY SUPERVISORS IN CLOSE COOPERATION WITH STAKEHOLDERS Building supervisory capacity and convergence is a critical enabler for other benefits of digitalisation; without strong and convergent supervision, other benefits may be compromised. With the use of different tools available (innovation hubs, regulatory sandboxes, market monitoring, public consultations, desk-based reports etc.), supervisors seek to understand, engage and supervise increasingly technology-driven undertakings.
Closely cooperating with stakeholders with hands-on experience on the use of innovative tools has proofed to be useful tool to improve the knowledge by supervisors, and also for the stakeholders it is important to understand what are the supervisory expectations.
Certainly, the profile of the supervisors needs to evolve and they need to extend their knowledge into new areas and understand how new business models and value chains may impact undertakings and intermediaries both from a conduct and from a prudential perspective. Moreover, in view of the growing importance of new technologies and business models for insurance undertakings and pensions schemes, it is important to ensure that supervisors have access to relevant data about these developments in order to enable an evidence-based supervision.
EIOPA aims to continue incentivising the sharing of knowledge and experience amongst NCAs by organising InsurTech roundtables, workshops and seminars for supervisors as well as pursuing further potential deep-dive analysis on certain financial innovation topics. EIOPA will also further emphasise an evidence-based supervisory approach by developing a regular collection of harmonised data on digitalisation topics. EIOPA will also develop a stakeholder engagement strategy on digitalisation topics to identify those actors and areas where the cooperation should be reinforced.
The unexpected COVID-19 virus outbreak led European countries to shut down major part of their economies aiming at containing the outbreak. Financial markets experienced huge losses and flight-to-quality investment behaviour. Governments and central banks committed to the provision of significant emergency packages to support the economy, as the economic shock, caused by demand and supply disruptions accompanied by its reflection to the financial markets, is expected to challenge economic growth, labour market and the consumer sentiment across Europe for an uncertain period of time.
Amid an unprecedented downward shift of interest rate curves during March, reflecting the flight-to-quality behaviour, credit spreads of corporates and sovereigns increased for riskier assets, leading effectively to a double-hit scenario. Equity markets dramatically dropped showing extreme levels of volatility responding to the uncertainties on virus effects and on the status of government and central banks support programs and their effectiveness. Despite the stressed market environment, there were signs of improvement following the announcements of the support packages and during the course of the initiatives of gradually reopening the economies. The virus outbreak also led to extraordinary working conditions, with part of the services sector working from home, which rises the potential of those conditions being preserved after the virus outbreak, which could decrease demand and market value for commercial real estate investments.
Within this challenging environment, insurers are exposed in terms of solvency risk, profitability risk and reinvestment risk. The sudden reassessment of risk premia and the increase of default risk could trigger large-scale rating downgrades and result in decreased investments’ value for insurers and IORPs, especially for exposures to highly indebted corporates and sovereigns. On the other hand, the risk of ultra-low interest rates for long has further increased. Factoring in the knock on effects of the weakening macro economy, future own funds position of the insurers could be further challenged, due to potential lower levels of profitable new business written accompanied by increased volume of profitable in-force policies being surrendered or lapsed.
Finally, liquidity risk has resurfaced, due to the potential of mass lapse type of events and higher than expected virus and litigation related claims accompanied by the decreased inflows of premiums.
For the European occupational pension sector, the negative impact of COVID-19 on the asset side is mainly driven by deteriorating equity market prices, as, in a number of Member States, IORPs allocate significant proportions of the asset portfolio (up to nearly 60%) in equity investments. However, the investment allocation is highly divergent amongst Member States, so that IORPs in other Member States hold up to 70% of their investments in bonds, mostly sovereign bonds, where the widening of credit spreads impair their market value. The liability side is already pressured due to low interest rates and, where market-consistent valuation is applied, due to low discount rates. The funding and solvency ratios of IORPs are determined by national law and, as could be seen in the 2019 IORP stress test results, have been under pressure and are certainly negatively impacted by this crisis. The current situation may lead to benefit cuts for members and may require sponsoring undertakings to finance funding gaps, which may lead to additional pressure on the real economy and on entities sponsoring an IORP.
Climate risks remain one of the focal points for the insurance and pension industry, with Environmental, Social and Governance (ESG) factors increasingly shaping investment decisions of insurers and pension funds but also affecting their underwriting. In response to climate related risks, the EU presented in mid-December the European Green Deal, a roadmap for making the EU climate neutral by 2050, providing actions meant to boost the efficient use of resources by
moving to a clean, circular economy and stop climate change,
revert biodiversity loss
and cut pollution.
At the same time, natural catastrophe related losses were milder than previous year, but asymmetrically shifted towards poorer countries lacking relevant insurance coverages.
Cyber risks have become increasingly relevant across the financial system in particular during the virus outbreak due to the new working conditions that the confinement measures imposed. Amid the extraordinary en masse remote working arrangements an increased number of cyber-attacks has been reported on both individuals and healthcare systems. With increasing attention for cyber risks both at national and European level, EIOPA contributed to building a strong, reliable, cyber insurance market by publishing its strategy for cyber underwriting and has also been actively involved in promoting cyber resilience in the insurance and pensions sectors.
The Solvency II Directive provides that certain areas of the framework should be reviewed by the European Commission at the latest by 1 January 2021, namely:
long-term guarantees measures and measures on equity risk,
methods, assumptions and standard parameters used when calculating the Solvency Capital Requirement standard formula,
Member States’ rules and supervisory authorities’ practices regarding the calculation of the Minimum Capital Requirement,
group supervision and capital management within a group of insurance or reinsurance undertakings.
Against that background, the European Commission issued a request to EIOPA for technical advice on the review of the Solvency II Directive in February 2019 (call for advice – CfA). The CfA covers 19 topics. In addition to topics that fall under the four areas mentioned above, the following topics are included:
transitional measures
risk margin
Capital Markets Union aspects
macroprudential issues
recovery and resolution
insurance guarantee schemes
freedom to provide services and freedom of establishment
reporting and disclosure
proportionality and thresholds
best estimate
own funds at solo level
EIOPA is requested to provide technical advice by 30 June 2020.
Executive summary
This consultation paper sets out technical advice for the review of Solvency II Directive. The advice is given in response to a call for advice from the European Commission. EIOPA will provide its final advice in June 2020. The call for advice comprises 19 separate topics. Broadly speaking, these can be divided into three parts.
Firstly, the review of the long term guarantee measures. These measures were always foreseen as being reviewed in 2020, as specified in the Omnibus II Directive. A number of different options are being consulted on, notably on extrapolation and on the volatility adjustment.
Secondly, the potential introduction of new regulatory tools in the Solvency II Directive, notably on macro-prudential issues, recovery and resolution, and insurance guarantee schemes. These new regulatory tools are considered thoroughly in the consultation.
Thirdly, revisions to the existing Solvency II framework including in relation to
freedom of services and establishment;
reporting and disclosure;
and the solvency capital requirement.
Given that the view of EIOPA is that overall the Solvency II framework is working well, the approach here has in general been one of evolution rather than revolution. The principal exceptions arise as a result either of supervisory experience, for example in relation to cross-border business; or of the wider economic context, in particular in relation to interest rate risk. The main specific considerations and proposals of this consultation paper are as follows:
Considerations to choose a later starting point for the extrapolation of risk-free interest rates for the euro or to change the extrapolation method to take into account market information beyond the starting point.
Considerations to change the calculation of the volatility adjustment to risk-free interest rates, in particular to address overshooting effects and to reflect the illiquidity of insurance liabilities.
The proposal to increase the calibration of the interest rate risk submodule in line with empirical evidence. The proposal is consistent with the technical advice EIOPA provided on the Solvency Capital Requirement standard formula in 2018.
The proposal to include macro-prudential tools in the Solvency II Directive.
The proposal to establish a minimum harmonised and comprehensive recovery and resolution framework for insurance.
A background document to this consultation paper includes a qualitative assessment of the combined impact of all proposed changes. EIOPA will collect data in order to assess the quantitative combined impact and to take it into account in the decision on the proposals to be included in the advice. Beyond the changes on interest rate risk EIOPA aims in general for a balanced impact of the proposals.
The following paragraphs summarise the main content of the consulted advice per chapter.
Long-term guarantees measures and measures on equity risk
EIOPA considers to choose a later starting point for the extrapolation of risk-free interest rates for the euro or to change the extrapolation method to take into account market information beyond the starting point. Changes are considered with the aim to avoid the underestimation of technical provisions and wrong risk management incentives. The impact on the stability of solvency positions and the financial stability is taken into account. The paper sets out two approaches to calculate the volatility adjustment to the risk-free interest rates. Both approaches include application ratios to mitigate overshooting effects of the volatility adjustment and to take into account the illiquidity characteristics of the insurance liabilities the adjustment is applied to.
One approach also establishes a clearer split between a permanent component of the adjustment and a macroeconomic component that only exists in times of wide spreads.
The other approach takes into account the undertakings-specific investment allocation to further address overshooting effects.
Regarding the matching adjustment to risk-free interest rates the proposal is made to recognise in the Solvency Capital Requirement standard formula diversification effects with regard to matching adjustment portfolios. The advice includes proposals to strengthen the public disclosure on the long term guarantees measures and the risk management provisions for those measures.
The advice includes a review of the capital requirements for equity risk and proposals on the criteria for strategic equity investments and the calculation of long-term equity investments. Because of the introduction of the capital requirement on long-term equity investments EIOPA intends to advise that the duration-based equity risk sub-module is phased out.
Technical provisions
EIOPA identified a larger number of aspects in the calculation of the best estimate of technical provisions where divergent practices among undertakings or supervisors exist. For some of these issues, where EIOPA’s convergence tools cannot ensure consistent practices, the advice sets out proposals to clarify the legal framework, mainly on
contract boundaries,
the definition of expected profits in future premiums
and the expense assumptions for insurance undertakings that have discontinued one product type or even their whole business.
With regard to the risk margin of technical provisions transfer values of insurance liabilities, the sensitivity of the risk margin to interest rate changes and the calculation of the risk margin for undertakings that apply the matching adjustment or the volatility adjustment were analysed. The analysis did not result in a proposal to change the calculation of the risk margin.
Own funds
EIOPA has reviewed the differences in tiering and limits approaches within the insurance and banking framework, utilising quantitative and qualitative assessment. EIOPA has found that they are justifiable in view of the differences in the business of both sectors.
Solvency Capital Requirement standard formula
EIOPA confirms its advice provided in 2018 to increase the calibration of the interest rate risk sub-module. The current calibration underestimates the risk and does not take into account the possibility of a steep fall of interest rate as experienced during the past years and the existence of negative interest rates. The review
of the spread risk sub-module,
of the correlation matrices for market risks,
the treatment of non-proportional reinsurance,
and the use of external ratings
did not result in proposals for change.
Minimum Capital Requirement
Regarding the calculation of the Minimum Capital Requirement it is suggested to update the risk factors for non-life insurance risks in line with recent changes made to the risk factors for the Solvency Capital Requirement standard formula. Furthermore, proposals are made to clarify the legal provisions on noncompliance with the Minimum Capital Requirement.
Reporting and disclosure
The advice proposes changes to the frequency of the Regular Supervisory Report to supervisors in order to ensure that the reporting is proportionate and supports risk-based supervision. Suggestions are made to streamline and clarify the expected content of the Regular Supervisory Report with the aim to support insurance undertakings in fulfilling their reporting task avoiding overlaps between different reporting requirements and to ensure a level playing field. Some reporting items are proposed for deletion because the information is also available through other sources. The advice includes a review of the reporting templates for insurance groups that takes into account earlier EIOPA proposals on the templates of solo undertakings and group specificities.
EIOPA proposes an auditing requirement for balance sheet at group level in order to improve the reliability and comparability of the disclosed information. It is also suggested to delete the requirement to translate the summary of that report.
Proportionality
EIOPA has reviewed the rules for exempting insurance undertakings from the Solvency II Directive, in particular the thresholds on the size of insurance business. As a result, EIOPA proposes to maintain the general approach to exemptions but to reinforce proportionality across the three pillars of the Solvency II Directive.
Regarding thresholds EIOPA proposes to double the thresholds related to technical provisions and to allow Member States to increase the current threshold for premium income from the current amount of EUR 5 million to up to EUR 25 million.
EIOPA had reviewed the simplified calculation of the standard formula and proposed improvements in 2018. In addition to that the advice includes proposals to simplify the calculation of the counterparty default risk module and for simplified approaches to immaterial risks. Proposals are made to improve the proportionality of the governance requirements for insurance and reinsurance undertakings, in particular on
key functions (cumulation with operational functions, cumulation of key functions other than the internal audit, cumulation of key and AMSB function)
own risk and solvency assessment (ORSA) (biennial report),
written policies (review at least once every three years)
and administrative, management and supervisory bodies (AMSB) ( evaluation shall include an assessment on the adequacy of the composition, effectiveness and internal governance of the administrative, management or supervisory body taking into account the nature, scale and complexity of the risks inherent in the undertaking’s business)
Proposals to improve the proportionality in reporting and disclosure of Solvency II framework were made by EIOPA in a separate consultation in July 2019.
Group supervision
EIOPA proposes a number of regulatory changes to address the current legal uncertainties regarding supervision of insurance groups under the Solvency II Directive. This is a welcomed opportunity as the regulatory framework for groups was not very specific in many cases while in others it relies on the mutatis mutandis application of solo rules without much clarifications.
In particular, there are policy proposals to ensure that the
definitions applicable to groups,
scope of application of group supervision
and supervision of intragroup transactions, including issues with third countries
are consistent.
Other proposals focus on the rules governing the calculation of group solvency, including own funds requirements as well as any interaction with the Financial Conglomerates Directive. The last section of the advice focuses on the uncertainties related to the application of governance requirements at group level.
Freedom to provide services and freedom of establishment
EIOPA further provides suggestions in relation to cross border business, in particular to support efficient exchange of information among national supervisory authorities during the process of authorising insurance undertakings and in case of material changes in cross-border activities. It is further recommended to enhance EIOPA’s role in the cooperation platforms that support the supervision of cross-border business.
Macro-prudential policy
EIOPA proposes to include the macroprudential perspective in the Solvency II Directive. Based on previous work, the advice develops a conceptual approach to systemic risk in insurance and then analyses the current existing tools in the Solvency II framework against the sources of systemic risk identified, concluding that there is the need for further improvements in the current framework.
Against this background, EIOPA proposes a comprehensive framework, covering the tools initially considered by the European Commission (improvements in Own Risk and Solvency Assessment and the prudent person principle, as well as the drafting of systemic risk and liquidity risk management plans), as well as other tools that EIOPA considers necessary to equip national supervisory authorities with sufficient powers to address the sources of systemic risk in insurance. Among the latter, EIOPA proposes to grant national supervisory authorities with the power
to require a capital surcharge for systemic risk,
to define soft concentration thresholds,
to require pre-emptive recovery and resolution plans
and to impose a temporarily freeze on redemption rights in exceptional circumstances.
Recovery and resolution
EIOPA calls for a minimum harmonised and comprehensive recovery and resolution framework for (re)insurers to deliver increased policyholder protection and financial stability in the European Union. Harmonisation of the existing frameworks and the definition of a common approach to the fundamental elements of recovery and resolution will avoid the current fragmented landscape and facilitate cross-border cooperation. In the advice, EIOPA focuses on the recovery measures including the request for pre-emptive recovery planning and early intervention measures. Subsequently, the advice covers all relevant aspects around the resolution process, such as
the designation of a resolution authority,
the resolution objectives,
the need for resolution planning
and for a wide range of resolution powers to be exercised in a proportionate way.
The last part of the advice is devoted to the triggers for
early intervention,
entry into recovery and into resolution.
Other topics of the review
The review of the ongoing appropriateness of the transitional provisions included in the Solvency II Directive did not result in a proposal for changes. With regard to the fit and proper requirements of the Solvency II Directive EIOPA proposes to clarify the position of national supervisory authorities on the ongoing supervision of propriety of board members and that they should have effective powers in case qualifying shareholders are not proper. Further advice is provided in order to increase the efficiency and intensity of propriety assessments in complex cross-border cases by providing the possibility of joint assessment and use of EIOPA’s powers to assist where supervisors cannot reach a common view.
The global and European economic outlook has deteriorated in the past months with weakening industrial production and business sentiment and ongoing uncertainties about trade disputes and Brexit. In particular, the “low for long” risk has resurfaced in the EU, as interest rates reached record lows in August 2019 and an increasing number of countries move into negative yield territory for their sovereign bonds even at longer maturities in anticipation of a further round of monetary easing by central banks and a general flight to safety. Bond yields and swap rates have since slightly recovered again, but protracted low interest rates form the key risk for both insurers and pension funds and put pressure on both the capital position and long-term profitability. Large declines in interest rates can also create further incentives for insurers and pension funds to search for yield, which could add to the build-up of vulnerabilities in the financial sector if not properly managed.
Despite the challenging environment, the European insurance sector remains overall well capitalized with a median SCR ratio of 212% as of Q2 2019. However, a slight deterioration could be observed for life insurers in the first half of 2019 and the low interest rate environment is expected to put further pressures on the capital positions of life insurers in the second half of 2019. At the same time, profitability improved in the first half of 2019, mainly due to valuation gains in the equity and bond portfolios of insurers. Nevertheless, the low yield environment is expected to put additional strains on the medium to long term profitability of insurers as higher yielding bonds will have to be replaced by lower yielding bonds, which may make it increasingly difficult for insurers to make investment returns in excess of guaranteed returns issued in the past, which are still prevalent in many countries.
THE EUROPEAN INSURANCE SECTOR
The challenging macroeconomic environment is leading insurance undertakings to further adapt their business models. In order to address the challenges associated with the low yield environment and improve profitability, life insurers are lowering guaranteed rates in traditional products and are increasingly focusing on unit-linked products. On the investment side, insurers are slowly moving towards more alternative investments and illiquid assets, such as unlisted equity, mortgages & loans, infrastructure and property. For non-life insurers, the challenge is mostly focused on managing increasing losses stemming from climate-related risks and cyber events, which may not be adequately reflected in risk models based on historical data, and continued competitive pressures.
Despite the challenging environment, the European insurance sector overall gross written premiums slightly grew by 1.6% on an annual basis in Q2 2019. This growth is particularly driven by the increase in non life GWP (3.7%), in comparison to a slightly decrease in life (-0.5%). This reduction growth rate in life GWP is associated to the slowdown in the economic growth; however this does not seem to have affected the growth of non-life GWP to the same extent. Overall GWP as a percentage of GDP slightly increased from 9% to 11% for the European insurance market, likewise total assets as a share of GDP improved from 70% to 74%. The share of unit-linked business has slightly declined notwithstanding the growth expectations. Even though insurers are increasingly trying to shift towards unit-linked business in the current low yield environment, the total share of unit-linked business in life GWP has slightly decreased from 42% in Q2 2018 to 40% in Q2 2019, likewise the share for the median insurance company declined from 34% in Q2 2018 to 31% in Q2 2019. Considerable differences remain across countries, with some countries still being plagued by low trust due to misselling issues in the past. Overall, the trend towards unit-lead business means that investment risks are increasingly transferred to policyholders with potential reputational risks to the insurance sector in case investment returns turn out lower than anticipated.
The liquid asset ratio slightly deteriorated in the first half of 2019. The median value for liquid asset increased by 1.5% from 63.3% in 2018 Q2 to 64.8% in 2018 Q4, and after slightly decreased to 63.8% in Q2 2019. Furthermore, the distribution moved down (10th percentile reduced in the past year by 6 p.p. to 47.9%). Liquid assets are necessary in order to meet payment obligations when they are due. Furthermore, a potential increase in interest rate yields might directly impact the liquidity needs of insurers due to a significant increase in the lapse rate as policyholders might look for more attractive alternative investments.
Lapse rates in the life business remained stable slightly increased in the first half of 2019. The median value increased from 1.34% in Q2 2018 to 1.38% in Q2 2019. Moreover, a potential sudden reversal of risk premia and abruptly rising yields could trigger an increase in lapse rates and surrender ratios as policyholders might look for more attractive investments. Although several contractual and fiscal implications could limit the impact of lapses and surrenders in some countries, potential lapses by policyholders could add additional strains on insurers’ financial position once yields start increasing.
The return on investment has substantially declined further over 2018. The investment returns have significantly deteriorated for the main investment classes (bonds, equity and collective instruments). The median return on investment decreased to only 0.31% in 2018, compared to 2.83% in 2016 and 1.95% in 2017. In particular the four main investment options (government and corporate bonds, equity instruments and collective investment undertakings) – which approximately account for two-thirds of insurers’ total investment portfolios – have generated considerably lower or even negative returns in 2018. As a consequence, insurers may increasingly look for alternative investments, such as unlisted equities, mortgages and infrastructure to improve investment returns. This potential search for yield behaviour might differ per country and warrants close monitoring by supervisory authorities as insurers may suffer substantial losses on these more illiquid investments when markets turn sour.
Despite the challenging investment climate, overall insurer profitability improved in the first half of 2019. The median return on assets (ROA) increased from 0.24% in Q2 2018 to 0.32% in Q2 2019, whereas the median return on excess of assets over liabilities (used as a proxy of return on equity), increased from 2.8% in Q2 2018 to 4.9 % in Q2 2019. The improvement in overall profitability seems to stem mainly from valuation gains in the investment portolio of insurers driven by a strong rebound in equity prices and declining yields (and hence increasing values of bond holdings) throughout the first half of 2019, while profitability could be further supported by strong underwriting results and insurers’ continued focus on cost optimisation. However, decreased expected profits in future premiums (EPIFP) from 11% in Q1 2019 to 10.3% in Q2 2019 suggest expectations of deteriorating profitability looking ahead. Underwriting profitability remained stable and overall positive in the first half of 2019. The median Gross Combined Ratio for non-life business remained below 100% in the first half of 2019 across all lines of business, indicating that most EEA insurers were able to generate positive underwriting results (excluding profits from investments). However, significant outliers can still be observed across lines of business, in particular for credit and suretyship insurance, indicating that several insurers have experienced substantial underwriting losses in this line of business. Furthermore, concerns of underpricing and underreserving remain in the highly competitive motor insurance markets.
Solvency positions slightly deteriorated in the first half of 2019 and the low interest rate environment is expected to put further pressures on the capital positions in the second half of the year, especially for life insurers. Furthermore, the number of life insurance undertakings with SCR ratios below the 100% threshold increased in comparison with the previous year from 1 in Q2 2018 to 4 in Q2 2019 mainly due to the low interest rate environment, while the number of non-life insurance undertakings with SCR ratios below 100% threshold decreased from 9 in Q2 2018 to 7 in Q2 2019. The median SCR ratio for life insurers is still the highest compared to non-life insurers and composite undertakings. However, the SCR ratio differs substantially among countries.
The impact of the LTG and transitional measures varies considerably across insurers and countries. The long term guarantees (LTG) and transitional measures were introduced in the Solvency II Directive to ensure an appropriate treatment of insurance products that include long-term guarantees and facilitate a smooth transition of the new regime. These measures can have a significant impact on the SCR ratio by allowing insurance undertakings, among others, to apply a premium to the risk free interest rate used for discounting technical provions. The impact of applying these measures is highest in DE and the UK, where the distribution of SCR ratios is signicantly lower without LTG and transitional measures (Figure 2.16). While it is important to take the effect of LTG measures and transitional measures into account when comparing across insurers and countries, the LTG measures do provide a potential financial stability cushion by reducing overall volatility.
On October 15th 2019, EIOPA launched a public consultation on an Opinion that sets out technical advice for the 2020 review of Solvency II. The call for advice comprises 19 separate topics. Broadly speaking, these can be divided into three parts.
The review of the LTG measures, where a number of different options are being consulted on, notably on extrapolation and on the volatility adjustment.
The potential introduction of new regulatory tools in the Solvency II framework, notably on macro-prudential issues, recovery and resolution, and insurance guarantee schemes. These new regulatory tools are considered thoroughly in the consultation.
Revisions to the existing Solvency II framework including in relation to
freedom of services and establishment;
reporting and disclosure;
and the solvency capital requirement.
The main specific considerations and proposals of this consultation are as follows:
Considerations to choose a later starting point for the extrapolation of risk-free interest rates for the euro or to change the extrapolation method to take into account market information beyond the starting point.
Considerations to change the calculation of the volatility adjustment to risk-free interest rates, in particular to address overshooting effects and to reflect the illiquidity of insurance liabilities.
The proposal to increase the calibration of the interest rate risk sub-module in line with empirical evidence, in particular the existence of negative interest rates. The proposal is consistent with the technical advice EIOPA provided on the Solvency Capital Requirement standard formula in 2018.
The proposal to include macro-prudential tools in the Solvency II Directive.
The proposal to establish a minimum harmonised and comprehensive recovery and resolution framework for insurance.
The European Supervisory Authorities (ESAs) published on the 4th October 2019 a Joint Opinion on the risks of money laundering and terrorist financing affecting the European Union’s financial sector. In this Joint Opinion, the ESAs identify and analyse current and emerging money laundering and terrorist financing (ML/ TF) risks to which the EU’s financial sector is exposed. In particular, the ESAs have identified that the main cross-cutting risks arise from
the withdrawal of the United Kingdom (UK) from the EU,
new technologies,
virtual currencies,
legislative divergence and divergent supervisory practices,
weaknesses in internal controls,
terrorist financing and de-risking;
in order to mitigate these risks, the ESAs have proposed a number of potential actions for the Competent Authorities.
Following its advice to the European Commission on the integration of sustainability risks in Solvency II and the Insurance Distribution Directive on April 2019, EIOPA has published on 30th September 2019 an Opinion on Sustainability within Solvency II, which addresses the integration of climate-related risks in Solvency II Pillar I requirements. EIOPA found no current evidence to support a change in the calibration of capital requirements for “green” or “brown” assets. In the opinion, EIOPA calls insurance and reinsurance undertakings to implement measures linked with climate change-related risks, especially in view of a substantial impact to their business strategy; in that respect, the importance of scenario analysis in the undertakings’ risk management is highlighted. To increase the European market and citizens’ resilience to climate change, undertakings are called to consider the impact of their underwriting practices on the environment. EIOPA also supports the development of new insurance products, adjustments in the design and pricing of the products and the engagement with public authorities, as part of the industry’s stewardship activity.
On the 15th July 2019 EIOPA submitted to the European Commission draft amendments to the Implementing technical standards (ITS) on reporting and the ITS on public disclosure. The proposed amendments are mainly intended to reflect the changes in the Solvency II Delegated Regulation by the Commission Delegated Regulation (EU) 2019/981 and the Commission Delegated Regulation 2018/1221 as regards the calculation of regulatory capital requirements for securitisations and simple, transparent and standardised securitisations held by insurance and reinsurance undertakings. A more detailed review of the reporting and disclosure requirements will be part of the 2020 review of Solvency II.
On 18th June 2019 the Commission Delegated Regulation (EU) 2019/981 amending the Solvency II Delegated Regulation with respect to the calculation of the SCR for standard formula users was published. The new regulation includes the majority of the changes proposed by EIOPA in its advice to the Commission in February 2018 with the exception of the proposed change regarding interest rate risk. Most of the changes are applicable since July 2019, although changes to the calculation of the loss-absorbing capacity of deferred taxes and non-life and health premium and reserve risk will apply from 1 January 2020.
RISK ASSESSMENT
QUALITATIVE RISK ASSESSMENT
EIOPA conducts twice a year a bottom-up survey among national supervisors to determine the key risks and challenges for the European insurance and pension fund sectors, based on their probability and potential impact.
The EIOPA qualitative Autumn 2019 Survey reveals that low interest rates remain the main risks for both the insurance and pension fund sectors. Equity risks also remain prevalent, ranking as the 3rd and 2nd biggest risk for the insurance and pension funds sectors respectively. The cyber risk category is now rank as the 2nd biggest risk for the insurance sector, as insurers need to adapt their business models to this new type of risk both from an operational risk perspective and an underwriting perspective. Geopolitical risks have become more significant for both markets, along with Macro risks, which continue to be present in the insurance and pension fund sectors, partially due to concerns over protectionism, trade tensions, debt sustainability, sudden increase in risk premia and uncertainty relating to the potential future post-Brexit landscape.
The survey further suggests that all the risks are expected to increase over the coming year. The increased risk of the low for long interest rate environment is in line with the observed market developments, particulary after the ECB’s announcement of renewed monetary easing in September 2019. The significant expected raise of cyber, property, equity, macro and geopolitical risks in the following year is also in line with the observed market developments, indicating increased geopolitical uncertainty, trade tensions, stretched valuations in equity and real estate markets and more frequent and sophisticated cyber attacks which could all potentially affect the financial position of insurers and pension funds. On the other hand, ALM risks and Credit risk for financials are expected to increase in the coming year, while in the last survey in Spring 2019 the expectations were following the opposite direction.
Although cyber risk is ranking as one of the top risks and expected to increase in the following year, many jurisdictions also see cyber-related insurance activities as a growth opportunity. The rapid pace of technological innovation and digitalisation is a challenge for the insurance market and insurers need to be able to adapt their business models to this challenging environment, nonetheless from a profitability perspective, increased digitalisation may offer significant cost-saving and revenue-increasing opportunities for insurance companies. The increase of awareness of cyber-risk and higher vulnerability to cyber threats among undertakings due to the increased adoption of digital technologies could drive a growth in cyber insurance underwriting.
The survey shows the exposure of an sudden correction of the risk premia significantly differs across EU countries. In the event of a sudden correction in the risk premia, insurance undertakings and pension funds with ample exposure to bonds and real estate, could suffer significant asset value variations that could lead to forced asset sales and potentially amplify the original shock to asset prices in less liquid markets. Some juridictions, however, confirm the limited exposure to this risk due to the low holding of fixed income instruments and well diversified portfolios.
The survey further indicates that national authorities expect the increase of investments in alternative asset classes and more illiquid assets. Conversely, holdings of governement bonds are expected to decrease in favour of corporate bonds within the next 12 months. Overall this might indicate potential search for yield behaviour and a shift towards more illiquid assets continues throughout numerous EU jurisdictions. Property investments – through for instance mortgages and infrastructure investment – are also expected to increase in some jurisdictions, for both insurers and pension funds. A potential downturn of real estate markets could therefore also affect the soundness of the insurance and pension fund sectors.
QUANTITATIVE RISK ASSESSMENT EUROPEAN INSURANCE SECTOR
This section further assesses the key risks and vulnerabilities for the European insurance sector identified in this report. A detailed breakdown of the investment portfolio and asset allocation is provided with a focus on specific country exposures and interconnectedness with the banking sector. The chapter also analyses in more detail the implications of the current low yield environment for insurers.
INVESTMENTS
Insurance companies’ investments remain broadly stable, with a slight move towards less liquid investment. Government and corporate bonds continue to make up the majority of the investment portfolio, with only a slight movement towards more non-traditional investment instruments such as unlisted equity and mortgage and loans. Life insurers in particular rely on fixed-income assets, due to the importance of asset-liability matching of their long-term obligations. At the same time, the high shares of fixed-income investments could give rise to significant reinvestment risk in the current low yield environment, in case the maturing fixed-income securities can only be replaced by lower yielding fixed-income securities for the same credit quality.
The overall credit quality of the bond portfolio is broadly satisfactory, although slight changes are observed in 2018. The vast majority of bonds held by European insurers are investment grade, with most rated as CQS1 (AA). However, the share of CQS2 has increased in the first half of 2019, and significant differences can be observed for insurers across countries.
INTERCONNECTEDNESS BETWEEN INSURERS AND BANKS
The overall exposures towards the banking sector remain significant for insurers in certain countries, which could be one potential transmission channel in case of a sudden reassessment of risk premia. The interconnectedness between insurers and banks could intensify contagion across the financial system through common risk exposures. A potential sudden reassessment of risk premia may not only affect insurers directly, but also indirectly through exposures to the banking sector. This is also a potential transmission channel of emerging markets distress, as banks have on average larger exposures to emerging markets when compared to insurers.
Another channel of risk transmission could be through different types of bank instruments bundled together and credited by institutional investors such as insurers and pension funds.
Insurers’ exposures towards banks are heterogeneous across the EU/EEA countries, with different levels of home bias as well. Hence, countries with primary banks exposed to emerging markets or weak banking sectors could be impacted more in case of economic distress. On average, 15.95% of the EU/EEA insurers’ assets are issued by the banking sector through different types of instruments, mostly bank bonds.
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