EIOPA outlines key financial stability risks of the European insurance and pensions sector

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.

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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.

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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.

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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.

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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.

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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.

  1. The review of the LTG measures, where a number of different options are being consulted on, notably on extrapolation and on the volatility adjustment.
  2. 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.
  3. 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.

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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.

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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.

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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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Click here to access EIOPA’s Dec 2019 Financial Stability Report

EIOPA’s Insurance Stress Test 2018 Recommendations

Introduction

During the course of 2018, EIOPA carried out a European-wide stress test (ST) in accordance with Articles 21(2)(b) and 32 of Regulation (EU) 1094/2010 of 24 November 2010 of the European Parliament and of the Council (hereafter the ‘Regulation’).

The Recommendations contained in this document are issued in accordance with Article 21(2)(b) of the Regulation in order to address issues identified in the stress test.

EIOPA will support National Competent Authorities (NCAs) and undertakings through guidance and other measures if needed.

The 2018 Stress Test results showed that on aggregate the insurance sector is sufficiently capitalised to absorb the combination of shocks prescribed in the three scenarios. However, it also confirms the significant sensitivity to market shocks for the European insurance sector with Groups being vulnerable

  • not only to low yields and longevity risk,
  • but also to a sudden and abrupt reversal of risk premia, combined with an instantaneous shock to lapse rates and claims inflation.

The exercise further reveals potential transmission channels of the tested shocks to insurers’ balance sheets. For instance, in the YCU scenario the assumed claim inflation shock leads to a net increase in the liabilities of those Groups more exposed to non-life business through claims inflation. Finally, both the YCD and YCU scenario have similar negative impact on post-stress SCR ratios.

As outlined in the Executive Summary of the 2018 Insurance Stress Test Report, further analyses of the results are required by EIOPA and the NCAs to obtain a deeper understanding of the risks and vulnerabilities of the sector.

In order to follow-up on the main vulnerabilities, EIOPA is issuing the present Recommendations related to the 2018 stress test exercise.

Recommendation 1
NCAs should strengthen the supervision of the Groups identified as facing greater exposure to Yield Curve Up and/or Yield Curve Down scenarios. This affects, in particular, those Groups where transitional measures have a greater impact.

Recommendation 2
NCAs should carefully review and, where necessary, challenge the capital and risk management strategies of the affected Groups. In particular:

  • NCAs should require Groups to clarify the impact of the stress test in terms of capital and risk management.
  • For the affected Groups, stress test scenarios similar to YCU and YCD should be properly considered in the risk management framework, including the ORSAs.
  • Review the risk appetite framework for the affected Groups.

Recommendation 3
NCAs should evaluate the potential management actions to be implemented by the affected Groups. In particular:

  • NCAs should require Groups to indicate the range of actions based on the results of the stress testing.
  • NCAs should assess if the actions identified are realistic in such stress scenarios.
  • NCAs should consider any eventual second-round effects.

Recommendation 4
NCAs should further contribute to enhance the stress test process.

Recommendation 5
NCAs should enhance cooperation and information exchange with other relevant Authorities, such as the ECB/SSM or other national authorities, concerning the stress test results of the affected insurers which form part of a financial conglomerate.

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EIOPA’s Supervisory Statement Solvency II: Application of the proportionality principle in the supervision of the Solvency Capital Requirement

EIOPA identified potential divergences in the supervisory practices concerning the supervision of the SCR calculation of immaterial sub-modules.

EIOPA agrees that in case of immaterial SCR sub-modules the principle of proportionality applies regarding the supervisory review process, but considers it is important to guarantee supervisory convergence as divergent approaches could lead to supervisory arbitrage.

EIOPA is of the view that the consistent implementation of the proportionality principle is a key element to ensure supervisory convergence for the supervision of the SCR. For this purpose the following key areas should be considered:

Proportionate approach

Supervisory authorities may allow undertakings, when calculating the SCR at the individual undertaking level, to adopt a proportionate approach towards immaterial SCR sub-modules, provided that the undertaking concerned is able to demonstrate to the satisfaction of the supervisory authorities that:

  1. the amount of the SCR sub-module is immaterial when compared with the total basic SCR (BSCR);
  2. applying a proportionate approach is justifiable taking into account the nature and complexity of the risk;
  3. the pattern of the SCR sub-module is stable over the last three years;
  4. such amount/pattern is consistent with the business model and the business strategy for the following years; and
  5. undertakings have in place a risk management system and processes to monitor any evolution of the risk, either triggered by internal sources or by an external source that could affect the materiality of a certain submodule.

This approach should not be used when calculating SCR at group level.

An SCR sub-module should be considered immaterial for the purposes of the SCR calculation when its amount is not relevant for the decision-making process or the judgement of the undertaking itself or the supervisory authorities. Following this principle, even if materiality needs to be assessed on a case-by-case basis, EIOPA recommends that materiality is assessed considering the weight of the sub-modules in the total BSCR and

  • that each sub-module subject to this approach should not represent more than 5% of the BSCR
  • or all sub-modules should not represent more than 10% of the BSCR.

For immaterial SCR sub-modules supervisory authorities may allow undertakings not to perform a full recalculation of such a sub-module on a yearly basis taking into consideration the complexity and burden that such a calculation would represent when compared to the result of the calculation.

Prudent calculation

For the sub-modules identified as immaterial, a calculation of the SCR submodule using inputs prudently estimated and leading to prudent outcomes should be performed at the time of the decision to adopt a proportionate approach. Such calculation should be subject to the consent of the supervisory authority.

The result of such a calculation may then be used in principle for the next three years, after which a full calculation using inputs prudently estimated is required so that the immateriality of the sub-module and the risk-based and proportionate approach is re-assessed.

During the three-year period the key function holder of the actuarial function should express an opinion to the administrative, management or supervisory body of the undertaking on the outcome of immaterial sub-module used for calculating SCR.

Risk management system and ORSA

Such a system should be proportionate to the risks at stake while ensuring a proper monitoring of any evolution of the risk, either triggered by internal sources such as a change in the business model or business strategy or by an external source such as an exceptional event that could affect the materiality of a certain sub-module.

Such a monitoring should include the setting of qualitative and quantitative early warning indicators (EWI), to be defined by the undertaking and embedded in the ORSA processes.

Supervisory reporting and public disclosure

Undertakings should include information on the risk management system in the ORSA Report. Undertakings should include structured information on the sub-modules for which a proportionate approach is applied in the Regular Supervisory Reporting and in the Solvency and Financial Condition Report (SFCR), under the section “E.2 Capital Management – Solvency Capital Requirement and Minimum Capital Requirement”.

Supervisory review process

The approach should be implemented in the context of on-going supervisory dialogue, meaning that the supervisory authority should be satisfied and agree with the approach taken and be kept informed in case of any material change. Supervisory authorities should inform the undertakings in case there is any concern with the approach. In case the supervisory authority has any concern the approach should not be implemented or might be implemented with additional safeguards as agreed between the supervisory authority and the undertaking.

In some situations supervisory authorities may require a full calculation following the requirements of the Delegated Regulation and using inputs prudently estimated.

Example : Supervisory reporting and public disclosure

Undertakings should include information on the risk management system referred to in the previous paragraphs in the ORSA Report.

Undertakings should include structured information on the sub-modules for which a proportionate approach is applied in the Regular Supervisory Reporting, under the section “E.2 Capital Management – Solvency Capital Requirement and Minimum Capital Requirement” (RSR), including at least the following information:

  1. identification of the sub-module(s) for which a proportionate approach was applied;
  2. amount of the SCR for such a sub-module in the last three years before the application of proportionate approach, including the current year;
  3. the date of the last calculation performed following the requirements of the Delegated Regulation using inputs prudently estimated; and
  4. early warning indicators identified and triggers for a calculation following the requirements of the Delegated Regulation and using inputs prudently estimated.

Undertakings should also include structured information on the sub-modules for which a proportionate approach is applied in the Solvency and Financial Condition Report, under the section “E.2 Capital Management – Solvency Capital Requirement and Minimum Capital Requirement” (SFCR), including at least the identification of the submodule(s) for which a proportionate calculation was applied.

An example of structured information to be included in the regular supervisory report in line with Article 311(6) of the Delegated Regulation is as follows:

Proportionality EIOPA

This proportionate approach should also be reflected in the quantitative reporting templates to be submitted. In this case the templates would reflect the amounts used for the last full calculation performed.

Click here to access EIOPA’s Supervisory Statement

Systemic Risk and Macroprudential Policy in Insurance (EIOPA)

In its work, EIOPA followed a step-by-step approach seeking to address the following questions in a sequential way:

  1. Does insurance create or amplify systemic risk?
  2. If yes, what are the tools already existing in the Solvency II framework, and how do they contribute to mitigate the sources of systemic risk?
  3. Are other tools needed and, if yes, which ones could be promoted?

Each paper published addresses one of the questions above. The publication of the three EIOPA papers on systemic risk and macroprudential policy in insurance has constituted an important milestone by which EIOPA has defined its policy stance and laid down its initial ideas on several relevant topics.

This work should now be turned into a specific policy proposal for additional macroprudential tools or measures where relevant and possible as part of the review of Directive 2009/138/EC (the ‘Solvency II5 Review’). For this purpose, and in order to gather the views of stakeholders, EIOPA is publishing this Discussion Paper on systemic risk and macroprudential policy in insurance, which focuses primarily on the third paper, i.e. on potential new tools and measures. Special attention is devoted to the four tools and measures specifically highlighted in the recent European Commission’s Call for Advice to EIOPA.

The financial crisis has shown the need to further consider the way in which systemic risk is created and/or amplified, as well as the need to have proper policies in place to address those risks. So far, most of the discussions on macroprudential policy have focused on the banking sector due to its prominent role in the recent financial crisis.

Given the relevance of the topic, EIOPA initiated the publication of a series of three papers on systemic risk and macroprudential policy in insurance with the aim of contributing to the debate and ensuring that any extension of this debate to the insurance sector reflects the specific nature of the insurance business.

EIOPA followed a step-by-step approach, seeking to address the following questions:

  • Does insurance create or amplify systemic risk? In the first paper entitled ‘Systemic risk and macroprudential policy in insurance’, EIOPA identified and analysed the sources of systemic risk in insurance and proposed a specific macroprudential framework for the sector. If yes, what are the tools already existing in the current framework, and how do they contribute to mitigate the sources of systemic risk? In the second paper, ‘Solvency II tools with macroprudential impact’, EIOPA identified, classified and provided a preliminary assessment of the tools or measures already existing within the Solvency II framework, which could mitigate any of the systemic risk sources that were previously identified.
  • Are other tools needed and, if yes, which ones could be promoted? The third paper carried out an initial assessment of other potential tools or measures to be included in a macroprudential framework designed for insurers. EIOPA focused on four categories of tools (capital and reservingbased tools, liquidity-based tools, exposure-based tools and pre-emptive planning). The paper focuses on whether a specific instrument should or should not be further considered. This is an important aspect in light of future work in the context of the Solvency II review.

The publication of the three EIOPA papers on systemic risk and macroprudential policy in insurance constitutes an important milestone by which EIOPA has defined its policy stance and laid down its initial ideas on several relevant topics. It should be noted that the ESRB (2018) has also identified a shortlist of options for additional provisions, measures and instruments, which reaches broadly similar conclusions as EIOPA.

EIOPA’s work should now be turned into a specific policy proposal for additional macroprudential tools or measures where relevant and possible as part of the Solvency II Review. For this purpose, and in order to gather the views of stakeholders, EIOPA is publishing this Discussion Paper on systemic risk and macroprudential policy in insurance.

This Discussion paper is based on the three papers previously published. They therefore back its content. Interested readers are recommended to consult them for further information or details. Relevant references are included in each of the sections.

EIOPA has included questions on all three papers. The majority of the questions, however, revolve around the third paper on additional tools or measures, which is more relevant in light of the Solvency II review.

The Discussion paper primarily focuses on the “principles” of each tool, trying to explain their rationale. As such, it does not address the operational aspects/challenges of each tool (e.g. calibration, thresholds, etc.) in a comprehensive manner. Similar to the approach followed with other legislative initiatives, the technical details could be addressed by means of technical standards, guidelines or recommendations, once the relevant legal instrument has been enacted.

Definitions

EIOPA provided all relevant definitions in EIOPA (2018a). It has to be noted, however, that there is usually no unique or universal definition for all these concepts. EIOPA’s work did not seek to fill this gap. Instead, working definitions are put forward in order to set the scene and should therefore be considered in the context of this paper only.

  • Financial stability and systemic risk are two strongly related concepts. Financial stability can be defined as a state whereby the build-up of systemic risk is prevented.
  • Systemic risk means a risk of disruption in the financial system with the potential to have serious negative consequences for the internal market and the real economy.
  • Macroprudential policy should be understood as a framework that aims at mitigating systemic risk (or the build-up thereof), thereby contributing to the ultimate objective of the stability of the financial system and, as a result, the broader implications for economic growth.
  • Macroprudential instruments are qualitative or quantitative tools or measures with system-wide impact that relevant competent authorities (i.e. authorities in charge of preserving the stability of the financial system) put in place with the aim of achieving financial stability.

In the context of this paper, these concepts (i.e. tools, instruments and measures) are used as synonyms.

The macroprudential policy approach contributes to the stability of the financial system — together with other policies (e.g. monetary and fiscal) as well as with microprudential policies. Whereas microprudential policies primarily focus on individual entities, the macroprudential approach focuses on the financial system as a whole.

It should be taken into account that, in some cases, the borders between microprudential policies and macroprudential consequences are blurring. That means, for example, that instruments that may have been designed as microprudential instrument may also have macroprudential consequences.

There are different institutional models for the implementation of macroprudential policies across EU, in some cases involving different parties (e.g. ministries, supervisors, etc.). This paper adopts a neutral approach by referring to the generic concept of the ‘relevant authority in charge of the macroprudential policy’, which should encompass the different institutional models existing across jurisdictions. Sometimes a simplified term such as ‘the authorities’ or ‘the competent authorities’ is used.

Systemic risk in insurance

While a common understanding of the systemic relevance of the banking sector has been reached, the issue is still debated in the case of the insurance sector. In order to contribute to this debate, EIOPA developed a conceptual approach to illustrate the dynamics in which systemic risk in insurance can be created or amplified.

Main elements of EIOPA’s conceptual approach to systemic risk

  • Triggering event: Exogenous event that has an impact on one or several insurance companies and may initiate the whole process of systemic risk creation. Examples are macroeconomic factors (e.g. raising unemployment), financial factors (e.g. yield movements) or non-financial factors (e.g. demographic changes or cyber-attacks).
  • Company risk profile: The result of the collection of activities performed by the insurance company. The activities will determine: a) the specific features of the company reflecting the strategic and operational decisions taken; and b) the risk factors that the company is exposed to, i.e. the potential vulnerabilities of the company.
  • Systemic risk drivers: Elements that may enable the generation of negative spill-overs from one or more company-specific stresses into a systemic effect, i.e. they may turn a company specific-stress into a system wide stress.
  • Transmission channels. Contagion channels that explain the process by which the sources of systemic risk may affect financial stability and/or the real economy. EIOPA distinguishes five main transmission channels: a) Exposure channel; b) Asset liquidation channel; c) Lack of supply of insurance products; d) Bank-like channel; and e) Expectations and information asymmetries
  • Sources of systemic risk: they result from the systemic risk drivers and their transmission channels. They are direct or indirect externalities whereby insurance imposes a systemic threat to the wider system. These direct and indirect externalities lead to three potential sources’ categories of systemic risks which are not mutually exclusive, i.e. entity-based related source, activity-based related source and behaviour-based related source.

In essence and as depicted in Figure 1, the approach developed by EIOPA considers that a ‘triggering event’ initially has an impact at entity level, affecting one or more insurers through their ‘risk profile’. Potential individual or collective distresses may generate systemic implications, the relevance of which is determined by the presence of different ‘systemic risk drivers’ embedded in the insurance companies.

EIOPA Sys Risk

In EIOPA’s view, systemic events could be generated in two ways.

  1. The ‘direct’ effect, originated by the failure of a systemically relevant insurer or the collective failure of several insurers generating a cascade effect. This systemic source is defined as ‘entity-based’.
  2. The ‘indirect’ effect, in which possible externalities are enhanced by engagement in potentially systemic activities (activity-based sources) or the widespread common reactions of insurers to exogenous shocks (behaviour-based source).

Potential externalities generated via direct and indirect sources are transferred to the rest of the financial system and to the real economy via specific channels (i.e. the transmission channel) and could induce changes in the risk profile of insurers, eventually generating potential second-round effects.

The following table provides an overview of possible examples of triggering events, risk profile, systemic risk drivers and transmission channels. It should therefore not be considered as a comprehensive list of elements.

EIOPA MacroPrud

Potential macroprudential tools and measures to enhance the current framework

In its third paper, EIOPA (2018c) carried out an analysis focusing on four categories of tools:

a) Capital and reserving-based tools;

b) Liquidity-based tools;

c) Exposure-based tools; and

d) Pre-emptive planning.

EIOPA also considers whether the tools should be used for enhanced reporting and monitoring or as intervention power. Following this preliminary analysis, EIOPA concluded the following :

EIOPA Other tools

Example: Enhancement of the ORSA 

Description. In an ORSA, an insurer is required to consider all material risks that may have an impact on its ability to meet its obligations to policyholders. In doing this a forward looking perspective is also required. Although conceived at first as a microprudential tool, this tool could be enhanced to take the macroprudential perspective also into account.

Potential contribution to mitigate systemic risk. The enhancement of ORSA could help in mitigating two of the sources of systemic risk identified.

Proposal. This measure is proposed for further consideration for enhanced reporting and monitoring purposes.

Operational aspects. A description of all relevant operational aspects is carried out in EIOPA (2018c). In essence, the idea is to supplement the microprudential approach by assigning certain roles and responsibilities to the relevant authority in charge of the macroprudential policy (see Figure below). This authority could carry out three different tasks:

  1. Aggregation of information;
  2. Analysis of the information; and
  3. Provision of certain information or parameters to supervisors to channel macroprudential concerns.

Supervisors would then request undertakings to include in their ORSAs particular macroprudential risks.

Issues for consideration: In order to make the ORSA operational from a macroprudential point of view, the following would be needed:

  • A clarification of the role of the risk management function in order to include macroprudential concerns.
  • The inclusion of a new paragraph in Article 45 of the Solvency II directive explicitly referring to the macroprudential dimension and the need to consider the macroeconomic situation and potential sources of systemic risk as followup of their assessment on whether the company complies on a continuous basis with the Solvency II regulatory capital requirements.
  • Clarification that a follow-up is expected after input from supervisors, namely from authorities in charge of the macroprudential policy. On a risk-based approach this might imply the request of specific information in terms of nature, scope, format and point in time, where justified by likelihood or impact of materialisation of a certain source of systemic risk.

Furthermore, a certain level of harmonisation of the structure and content of the ORSA report would be needed, which would enable the identification of the relevant sections by the authorities in charge of macroprudential policies. This, however, would mean a change in the current approach followed with regard to the ORSA.

Click here to access EIOPA’s detailed Discussion Paper 2019

 

EIOPA: Potential macroprudential tools and measures to enhance the current insurance regulatory framework

The European Insurance and Occupational Pensions Authority (EIOPA) initiated in 2017 the publication of a series of papers on systemic risk and macroprudential policy in insurance. So far, most of the discussions concerning macroprudential policy have focused on the banking sector. The aim of EIOPA is to contribute to the debate, whilst taking into consideration the specific nature of the insurance business.

With this purpose, EIOPA has followed a step-by-step approach, seeking to address the following questions:

  • Does insurance create or amplify systemic risk?
  • If yes, what are the tools already existing in the current framework, and how do they contribute to mitigate the sources of systemic risk?
  • Are other tools needed and, if yes, which ones could be promoted?

While the two first questions were addressed in previous papers, the purpose of the present paper is to identify, classify and provide a preliminary assessment of potential additional tools and measures to enhance the current framework in the EU from a macroprudential perspective.

EIOPA carried out an analysis focusing on four categories of tools:

  1. Capital and reserving-based tools;
  2. Liquidity-based tools;
  3. Exposure-based tools; and
  4. Pre-emptive planning.

EIOPA also considers whether the tools should be used for enhanced reporting and monitoring or as intervention power. Following this preliminary analysis, EIOPA concludes the following (Table 1):

Table 1 Macro

It is important to stress that the paper essentially focuses on whether a specific instrument should or should not be further considered. This is an important aspect in light of future work in the context of the Solvency II review. As such, this work should be understood as a first step of the process and not as a formal proposal yet. Furthermore, EIOPA is aware that the implementation of tools also has important challenges. In this respect this report provides an overview of tools, main conclusions and observations, stressing also the main challenges.

Table 2 puts together the findings of all three papers published by EIOPA by linking

  1. sources of systemic risk and operational objectives (first paper),
  2. tools already available in the current framework (second paper)
  3. and other potential tools and measures to be further considered (current paper).

Table 2 Papers

The first paper, ‘Systemic risk and macroprudential policy in insurance’ aimed at identifying and analysing the sources of systemic risk in insurance from a conceptual point of view and at developing a macroprudential framework specifically designed for the insurance sector.

The second paper, ‘Solvency II tools with macroprudential impact’, identified, classified and provided a preliminary assessment of the tools or measures already existing within the Solvency II framework, which could mitigate any of the sources of systemic risk.

This third paper carries out an initial assessment of potential tools or measures to be included in a macroprudential framework designed for insurers, in order to mitigate the sources of systemic risk and contribute to the achievement of the operational objectives.

It covers six main issues:

  1. Identification of potential new instruments/measures. The tools will be grouped according to the following blocks:
    • Capital and reserving-based tools
    • Liquidity-based tools
    • Exposure-based tools
    • Pre-emptive planning
  2. Way in which the tools in each block contribute to achieving one or more of the operational objectives identified in previous papers.
  3. Interaction with Solvency II.
  4. Individual description of all the tools identified for each of the blocks. The following classification will be considered:
    • Enhanced reporting and monitoring tools and measures. They provide supervisors and other authorities with additional relevant information about potential risks and vulnerabilities that are or could be building up in the system. Authorities could then implement an array of measures to address them both at micro and macroprudential level (see annex for an inventory of powers potentially available to national supervisory authorities (NSAs)).
    • Intervention powers. These powers are currently not available as macroprudential tools. They are more intrusive and intervene more severely in the management of the companies. Examples could be additional buffers, limits or restrictions. They are only justified where the existing measures may not suffice to address the sources of systemic risk identified.
  5. Preliminary analysis per tool.
  6. Preliminary conclusion.

Four initial remarks should be made.

  1. First, although in several instances the measures and instruments are originally microprudential in nature, they could also be implemented as macroprudential instruments, if a systemically important institution or set of institutions or the whole market are targeted.
  2. Secondly, analysing potential changes on the long-term guarantees (LTG) measures and measures on equity risk that were introduced in the Solvency II directive, although out of the scope of this paper, could contribute to further enhance the framework from a macroprudential perspective. The focus of this paper is essentially on new tools, leaving aside the analysis of potential changes in the current LTG measures and measures on equity risk, which will be carried out in the context of the Solvency II review by 1 January 2021.
  3. Thirdly, when used as a macroprudential tool, the decision process may differ, given that there are different institutional models for the implementation of macroprudential policies across EU countries, in some cases involving different parties (e.g. ministries, supervisors, etc.). This paper seeks to adopt a neutral approach by referring to the concept of the ‘relevant authority in charge of the macroprudential authority’, which should encompass the different institutional models existing across jurisdictions.
  4. Fourthly, there seems to be no single solution when it comes to the level of application of each tool (single vs. group level).

Concerning the different proposed monitoring tools, in the follow-up work, the structure and content of the additional data requirements should be defined. This should then be followed by an assessment of the potential burden of collecting this information from undertakings.

It is important to stress that this paper essentially focuses on whether a specific instrument should or should not be further considered. This is an important aspect in light of future work in the context of the Solvency II review. As such, this work should be understood as a first step of the process and not as a formal proposal yet.

Figure ORSA

Click here to access EIOPA’s detailed discussion paper

EIOPA Risk Dashboard January 2018

Risks originating from the macroeconomic environment remained stable and high. Improvements have been observed across most indicators, but were not sufficient to change the overall risk picture. The improving prospects for economic growth still contrast with the persistence of structural imbalances, such as fiscal deficit. The accommodative stance of monetary policy has been reduced only very gradually, with low interest rates continuing to put a strain on the insurance sector.

Credit risks remained constant at a medium level whereas observed spreads continued to decline. The average rating of investments has seen some marginal improvements. Concerns on the pricing of the risk premia remain.

Market risks remained stable at a medium level despite a reduction of the volatility on prices was observed. Only price to book value of European stocks moved in the direction of risk increase.

Liquidity and funding risks were constant at a medium level in 2017 Q3 and remained a minor issue for insurers. Catastrophe bond issuance significantly decreased when compared to the record high registered during the previous quarter. The low volume of issued bonds made the indicator less relevant.

Profitability and solvency risks remained stable at a medium level. A deterioration of the net combined ratio was observed in the tail (90 percentile) of the distribution mainly populated by reinsurers in this quarter. SCR ratios have improved across all types of insurers mainly due to an increase of the Eligible Own Funds. This has been especially marked for life solo companies.

Interlinkages & imbalances: Risks in this category remained constant at a medium level. Investment exposures to banks and other insurers increased slightly from the previous quarter.

Insurance risks increased when compared to 2017 Q2 and are now at a medium level. This was essentially driven by the significant increase in the catastrophe loss ratio resulting from the impact of the catastrophic events observed in Q3 mainly on reinsurers’ technical results. This is also reflected in the loss ratio. Other indicators in this risk category still point to a stable risk exposure.

Market perceptions remained constant, with the improvement in external rating outlooks outweighing the observed increase in price to earnings ratios. Insurance stocks slightly outperformed the market, especially for life insurance, and CDS spreads reduced.

Riskdashboard 12018

Click here to access EIOPA’s Risk Dashboard January 2018

How to successfully mitigate your organization’s third-party risk

What Is Third-Party Risk Management & Third-Party Due Diligence?

Third-party risk management is the process of assessing and controlling reputational, financial and legal risks to your organization posed by parties outside your organization. Third-party due diligence is the investigative process by which a third party is reviewed to determine any potential concerns involving legal, financial or reputational risks. Due diligence is disciplined activity that includes reviewing, monitoring and managing communication over the entire vendor engagement life cycle.

The Risks Are Real

As we see in the news too often, lapses in leadership around managing third parties have damaged organizations by exposing them to massive fines and penalties. According to the 2016 Benchmark Report, one-third of respondent organizations have faced legal or regulatory issues that involved third parties, with 50 percent of these involving average costs per incident of $10,000 or more. Even if the financial penalty can be managed, the reputational impact can have far-reaching consequences for many years. Third-party risk management is a top concern of compliance leaders, but many organizations are still coming to terms with how best to manage their third parties to limit risk and develop programs based on organizational risk assessments. The 2016 NAVEX Global benchmark report found that many organizations think they could be doing a better job of third-party risk management. Only 58 percent reported that they do a good job of complying with laws and regulations, and less than 25 percent rate their overall program as Good. Organizations may be diligent with their ethics and compliance programs, but for many the risk their third parties represent is a Wild West over which they feel like they have little control.

Benefits of a Strong Third-Party Risk Management Program

Managing third-party risk can make a big difference inhow well your organization can identify, manage and limit the liability a third party can represent. Your third party’s risk is your risk. You should have confidence that your program is minimizing that risk for you and your organization.

TPRClick here to access NAVEX detailed guide