Tag Archives: Europe

Compliance risk: Box-ticking or ticking all the boxes?

‘Box-ticking’ can be a phrase synonymous with poor practice in Enterprise Risk Management (ERM). When poorly executed it can mean going through the motions to display minimum levels of compliance, rather than engaging in any meaningful activity that would deliver any real benefit. Such an approach is not encouraged by regulators.

However, do companies, and indeed individuals, spend enough time making sure they have ticked all the boxes from a compliance perspective? This is an activity that regulators certainly encourage.

With the general direction of regulatory oversight and the formality of Solvency II, companies and boards are now confirming compliance in many areas. There is a risk that the compliance process itself becomes a risk. Compliance risk is one of those intangible issues that can’t be quantified using actuarial models or managed through setting aside capital. It is a risk that is dealt with on a qualitative basis and is managed and controlled rather than measured and capitalised. This means that managing compliance risk might not be front of mind for many companies, especially with such a focus on capital amounts and getting the numbers “right”.

This becomes even more apparent at this time of year, when statutory sign-offs and certifications come into play. If you are being asked to put pen to paper to certify compliance or sign-off on the accuracy of regulatory submissions, how do you know that all the requirements have been adequately met?

The implementation of Solvency II significantly increased the amount of requirements and guidance that companies and individuals have to follow in relation to certifying solvency. This is in addition to increased compliance in other areas over the last number of years, including the Corporate Governance Code in Ireland, policyholder disclosures, etc. A lot of governance tasks that would have developed over time based on industry knowledge and practical sense now have to run the rule against a checklist or a set of requirements.

The very nature of financial reporting is changing to fit this new world. Getting the numbers right is no longer enough, you now also have to evidence how you ensured the figures are accurate and reliable and not misleading. In a Solvency II world the sheer number of requirements (and the very prescriptive and specific nature of some of them) means that the only way to be sure that each and every requirement is covered is to sit down and mark each item off. It is boring, and it doesn’t feel particularly efficient or creative—but it is disciplined and leads to identifying areas for improvement. Going through this value-adding process of identifying and closing gaps in a systematic way clearly is valuable and can help you spot patterns over time. It is also the best way of documenting and demonstrating compliance.

Being able to demonstrate compliance is also a defensive requirement in this new Solvency II world. If an issue arises or a query is raised by a regulator, the drawbacks of ignoring compliance checks quickly become apparent. Your ability to defend what you do now from a challenge in the future depends on your audit trail. So as a parting thought—don’t be afraid to spend some time ticking boxes. It might be more valuable that you think.

The Milliman Solvency II Compliance Assessment Tool distils the Solvency II requirements into easily digestible self-assessment questions and allows insurers to track and evidence their compliance with all the requirements of Solvency II. The tool is already being used by 25 entities in Ireland and the UK. For more information click here.

The emergence of lapse risk transfer

This blog post is part of an ongoing series of blog posts on capital efficiency. To see past posts in this series, please click here.

In recent months, we have seen the emergence of lapse risk reinsurance following the introduction of Solvency II. Lapse risk is one of the key risks that life insurers, and particularly unit-linked life insurers, are exposed to and it is a key component of the Solvency II Solvency Capital Requirement (SCR) for many life insurers. One of the benefits of lapse risk reinsurance is that it can be used to reduce the life underwriting risk capital charge, in addition to reducing the undertaking’s exposure to lapse risk. Many reinsurers are active in this area, and as undertakings begin to consider Solvency II capital efficiency in more detail, it may be an area where we will see further growth during 2017.

Reinsurance treaties
The nature of lapse risk transfer will depend on the most material lapse risk exposure of the cedant—either mass lapse, lapse up, or lapse down.

The mass lapse scenario under Solvency II is calibrated as an instantaneous loss of 40% of the in-force business (for retail business). While the actual occurrences of mass lapse scenarios are difficult to predict, the risk of lapses exceeding 20% to 30% in a given period may be low based on historical data. Reinsurers can therefore offer treaties that cover losses caused by lapses in excess of 20% to 30% in a given period, often setting a maximum threshold of 45% to 50%. In reinsurance parlance, the reinsurance treaty attaches at a level of 20% or 30% and detaches at 45% or 50%. The relevant period would be defined in the reinsurance treaty. The cedant would retain the risk exposure to lapses below the attachment point and above the detachment point.

We are also aware of some reinsurers considering lapse up and lapse down reinsurance. However, there may be significant practical challenges associated with lapse reinsurance of this nature, in particular with regard to defining when an increase or decrease from the long-term average, or best estimate, lapse rates has occurred.

There are a number of general considerations in respect of lapse risk reinsurance (as well as other potential considerations, depending on the specific terms of an individual treaty). First of all, there is the premium charged by the reinsurer for transferring lapse risk. The cost is generally set with reference to the reduction in SCR achieved by the transaction. We understand that costs generally vary between around 2% to 3% per annum of the reduction in the lapse risk SCR, depending on the type of deal and the availability of data.

Buy-in from the regulators will be key for these contracts to be effective. There is likely to be a concern that reinsurance could be used to reduce the SCR without a real reduction in the underlying risk. It is difficult to argue that there is no reduction in lapse risk exposure in the example attachment points outlined above. However, it may be more difficult to justify real risk transfer where the treaty is set up in such a way as to only indemnify insurers when a mass lapse of exactly 40% occurs.

Other considerations include the following:
• The interaction between the different lapse risk components of the SCR needs to be considered. If the risk exposure to mass lapse is reduced through the use of reinsurance, the lapse up or lapse down risk module may bite instead. Therefore, the impact of mass lapse reinsurance will be limited to the margin over which the mass lapse SCR capital charge exceeds the next-highest lapse risk capital charge. Understanding this interaction will be an important factor in determining the optimal attachment point for a mass lapse reinsurance treaty.
• Reinsurance introduces additional risks to the balance sheet such as counterparty risk, which is also considered in the Solvency II SCR calculation.
• The impact of such a transaction on the financial statements or International Financial Reporting Standards (IFRS) balance sheet should also be considered.
• If the reinsurance contracts are short-term in nature, there may be a risk associated with getting renewal terms on the same basis.

An alternative
Insurance-linked securities offer an alternative approach to transferring risk compared with traditional reinsurance. Under these transactions, insurance risk is effectively securitised and bought by capital investors through an investment fund. We are aware of a number of insurance-linked security firms that are active in transferring lapse risk.

The solutions can be structured in a similar way to traditional reinsurance deals in terms of attachment and detachment points, although the deals tend to be longer in term than traditional reinsurance contracts (circa three to five years, as opposed to 12 to 18 months). This provides additional benefits in terms of impact on the Solvency II risk margin and also may be more preferable to regulators than short-term contracts. However, this results in slightly higher costs compared with traditional reinsurance deals.

One disadvantage is that insurance-linked security firms generally do not have credit ratings, which can result in a high capital charge for counterparty risk under Solvency II. However, it is possible to reduce this through the use of collateral.

A harmonized EIOPA Recovery and Resolution Framework discussion paper

king-eoinOn December 2, the European Insurance and Occupational Pensions Authority (EIOPA) issued a discussion paper on “Potential Harmonisation of Recovery and Resolution Frameworks for Insurers.” The paper sets out a number of considerations for the development of a harmonized European framework in the recovery and resolution planning space. It is open to comments from stakeholders until February 28, 2017.

Recovery and resolution planning is a very topical subject at present and there are numerous examples of requirements for financial services companies and regulatory authorities to develop recovery and resolution plans and frameworks. For example, larger financial institutions that are classified as globally systemically important financial institutions (G-SIFIs) and globally systemically important insurers (G-SIIs) are required to undertake recovery and resolution planning under the Financial Stability Board’s “Key Attributes of Effective Resolution Regimes for Financial Institutions” and similar requirements adopted by the International Association of Insurance Supervisors. This is also an area of focus for European regulators. In Ireland, for example, Sylvia Cronin, Director of Insurance Supervision at the Central Bank, noted at the European Insurance Forum in March that recovery and resolution for insurers is an area of particular interest for the Central Bank.

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Capital efficiency under Solvency II: Part II

clarke-sineadOur continuing series of blog posts addresses some ways in which companies may be able to achieve capital efficiency under Solvency II. This post looks at three additional capital management techniques that have become popular since the introduction of the new Solvency II capital regime.

Internal reinsurance
We have seen an increase in the use of internal reinsurance to improve Solvency II capital. The use of internal reinsurance can reduce the capital requirements of solo entities through risk transfer to the internal reinsurer. The group may also benefit from greater capital efficiencies through diversification at the reinsurer level.

Aviva significantly increased the amount of business ceded to its internal reinsurer,* Aviva International Insurance, during 2016. AXA also has an internal reinsurer to manage reinsurance for the insurer’s global property and casualty (P&C) business, which was recently upgraded by AM Best, and the Belgian insurer Ageas set up an internal reinsurance vehicle in 2015.*

Corporate restructuring
We have seen a large increase in mergers and acquisitions (M&A) activity and corporate restructuring as a result of Solvency II. Recent M&A activity includes:

• Scor announcing plans to merge its three French businesses* to reduce its risk margin by €200 million under Solvency II
• AXA’s exiting of the UK life and savings market with the sale of its offshore investment bonds business, Axa Isle of Man, and its UK portfolio services business, Elevate
• Aegon selling two-thirds of its UK annuity portfolio business to Rothesay Life with the aim of freeing up capital in its UK subsidiary
• Allianz selling its Taiwanese traditional life insurance portfolio* to a local Taiwanese life insurer to improve the group’s capital efficiency under Solvency II

Unit-linked matching
We are aware of a number of unit-linked providers that are currently rethinking unit-linked matching. The Solvency II regulations state that the technical provisions in respect of unit-linked benefits must be matched as closely as possible with unit-linked assets. Under Solvency II, the technical provisions for unit-linked benefits generally include a best estimate liability, which is lower than the unit value. This opens up the possibility to invest a lower amount in unit-linked assets than the outstanding unit value, i.e., “mismatching” the unit-linked assets and liabilities, which can enhance the capital position of unit-linked portfolios and stabilise economic balance sheets.

However, as usual, such benefits come at a price, and insurers will have to decide whether or not the capital savings are sufficient to offset the operational complexities, coupled with a more volatile solvency coverage ratio. Unit-linked matching is considered in more detail in our briefing note entitled Unit-linked matching considerations under Solvency II.

We have published a number of papers on this topic including Capital management in a Solvency II world, which focusses on life (re)insurance business, Capital management in a Solvency II world: A nonlife perspective (looking specifically at nonlife or P&C issues) and Unit-linked matching considerations under Solvency II.

If you are interested in more information on capital management under Solvency II please contact your usual Milliman consultant.

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Overview of Solvency II external audit considerations

With Solvency II’s public disclosure requirement, European countries are considering a variety of policies for the external audit of insurer information. A significant number of member states have not yet decided on making external audit an official requirement or the supervisor is not in the position to make external audit an official requirement. In this article, Milliman consultants Luca Inserra and Glennfor Hellement highlight which countries require an external audit, and provide more details on the scope of and reasons behind the external audit policies for Europe.

Economic volatility considerations for European insurers

Insurers and reinsurers use a vast number of expert resources to understand the rapidly changing nature of the risks they underwrite. Regulation also depletes resources at the board level as politicians and society demand tighter control of the financial sector. Politics plays a role, too. All of these challenges are in sharper focus now because of the regulatory pressures coming from the implementation of Solvency II. This Milliman Impact article examines some possible scenarios and their potential effects.