Articles - Solvency II implementation update

 Speech by Julian Adams, Director of Insurance, FSA

  

 This event marks an important stage on the road to the implementation of Solvency II here in the UK, as we move to the next phase of our programme of work with internal model firms.

  

 This takes place, of course, against a backdrop of ongoing uncertainty about Solvency II, both in the substance of the policy and the timescales for its implementation, but what we aim to do today is give you as much clarity as we can about what the position is and, just as importantly, what we are proposing to do over the coming months.

  

 Later today my colleague, Martin Etheridge, will be talking to you about our view of the latest policy position, and then we’ll be taking you through the detail of how our review process will work, and what you can expect to happen following your submission date. There will also be the opportunity for you to ask questions of our panel, and I hope you will take the opportunity to do so.

  

 Before all of that, I have a number of topics I want to cover with you this afternoon. The first of these is the ongoing uncertainty at a European level as to what the timeline for implementation will be, and when we and you will start to get some certainty about what important aspects of the new regime will look like.

 I then want to go on to explain what our approach has been to dealing with this uncertainty when designing the next stage of our process and putting together the supporting information and materials we are launching today, as well as describing how we are going to apply the principle of proportionality to our execution of that process.

  

 And finally, I want to touch a little bit on how all of this will interact with the UK’s domestic regulatory reform agenda, in particular looking at how the implementation of Solvency II will sit alongside the creation of the new Prudential Regulation Authority, which we currently expect in spring 2013.

  

 Policy uncertainty

  

 Turning first to the issue of policy uncertainty, I’d like to start by saying that the industry’s frustration with the ongoing lack of clarity is fully understandable. We appreciate that the lack of resolution of important issues – both in relation to what the new regime is going to look like, and in particular about when it is likely to commence and what the effect of transitionals will be – is disruptive to the implementation plans that the industry has spent a lot of time and effort putting into place. Martin will set out later how we expect the rest of the legislative process to be concluded over the coming months, and how that fits with our ongoing assumption that firms will be required to comply with the new regime from January 2014.

  

 You’ll be aware, of course, that the timetable is a very tight one, particularly in the context of a legislative process which has been far from straightforward, and I should share with you our views on what might happen if there is a further delay. We await a key vote in the European Parliament at the end of March, and it would clearly not take much further slippage in this to put transposition in January 2013 at risk, but this would not necessarily affect the implementation date for firms in January 2014. What it might do instead is merely compress the period between transposition and implementation. It therefore remains our assumption that the new regime will apply to firms from January 2014, and we have developed a plan which reflects this. Clearly, it is possible that this will change in the future, but for the time being we remain of the view that we must plan for a 2014 implementation.

  

 Our need to be able to apply the new regime to you from January 2014 is the reason we are pressing ahead with the developments we are outlining to you here today. It is also the reason why it is vitally important that you stick to the submission slots we have already agreed with you, as there is very little scope in our timetable for any form of slippage. By sticking to your submission slot you will also be considered alongside a peer group of firms, which will ensure a greater degree of consistency of approach.

  

 Clearly, if the position in relation to the implementation date changes again, we will communicate this to you as quickly as we can, along with an outline of what we expect the implications to be for our own implementation programme here in the UK. In doing so, we will attempt to respond in the same way as we did to the bifurcation proposal last autumn, that is seeking a path which optimises our own resource position and the work firms have already completed.

  

 Launch of the next phase of work

  

 I’d like to turn now to the main purpose of today’s event, which is the launch of the next phase of internal model approval work in the UK. Last year, when we announced our revised implementation assumptions based on implementation for firms in 2014, we took the view that it made sense to maintain the momentum that the UK industry had built up, and continue with our programme of model approval work. We also set out a position where it would potentially be open to firms to start using their Solvency II model to meet existing Individual Capital Adequacy Standards (ICAS) requirements where they wished to do so and where they could be satisfied that the model met all of the requirements of the current regime. As part of that, we decided that we would stick with our previously-announced ‘open for applications’ date of 30 March 2012.

  

 The purpose of today is to give you more information on what this next phase will look like, to set out the expectations we will have of you during this period, and to provide more detail on the support and guidance, which we will be making available to you before and during the application phase.

 Later on, some of my colleagues will be taking you through the process in detail, so in the meantime I would like to set this in the context of how we are approaching this issue, given the lack of clarity we have about a number of aspects of the underlying policy.

  

 As I mentioned at an Association of British Insurers (ABI) event in December, we are basing our approach to the next phase on the stable draft text of the Level 2 material which was circulated by the Commission in November. We are aware of the limitations associated with this approach, namely that first, it is not a final or complete articulation of what the policy will be, and second, that it is not technically a public document. Nonetheless, we feel that using the Level 2 material as it stands is the most sensible approach, as it represents the best available view of what the final position will be.

  

 We will be basing our internal decision-making materials on this Level 2 text, and will be publishing later today an updated version of the self assessment template based on this also. It is clearly possible that the Level 2 text will change as it gets closer to adoption, and we will review our materials and update them as needed. The new self-assessment template sets out the almost 300 requirements which the Directive identifies as having to be met before model approval can be granted, requirements which are derived from the Directive text and have not in any way been overlaid by us with additional UK criteria.

  

 We appreciate that this change will require some additional work for firms, in particular in the move from our previously published contents of application materials. We have not made this change lightly, but believe that it is important to do so, as it is the Level 2 text which will ultimately set out the standards which have to be met, and are therefore the standards against which your compliance – and ours – will have to be judged. The change also removes a number of items from the previous version which are now super-equivalent following changes to the text.

  

 I should also mention here also that the materials we are launching today do not take any account of the Level three text. This is insufficiently developed at this stage and lacks stability, meaning that it does not provide a meaningful platform for planning purposes. Again, we will ensure that our materials are updated in future to reflect any changes which may be required as the policy becomes clearer.

  

 An area in which we can provide some more clarity today is that of technical provisions. We are often asked whether a review of these will form part of our approval process for an internal model, given that technical provisions are the largest and most complex item on an insurer’s balance sheet. Our view is that we would not be able to approve a model under Solvency II without having reasonable assurance as to the accuracy of the underlying balance sheet, and we will therefore be undertaking a review of the technical provisions of IMAP firms as part of our existing activity with the firm before and after its submission slot. In the main, we envisage that there will be two elements for our review: the approach taken by firms and the actual calculation of technical provisions.

  

 Whilst we may be able to start a review of the approach this year, it is unlikely that we will review the calculation of technical provisions until a point in 2013, when firms will have prepared their year-end 2012 balance sheet on a Solvency II basis. We are considering the approach that we may take to our review of technical provisions, which may include the use of external review - something firms are already doing and which we have deployed for other aspects of Solvency II such as data management. Supervisors will start discussions with firms about the review of the approach to the calculation of technical provisions in the next few months, and we will provide further detail on our approach to the review of the calculation once we have sight of the finalised Level 2 text, probably this autumn.

  

 The Directive text – for model approval as with other matters – sets out criteria which have to be met in order for an approval to be granted. In the case of internal models approval, these are detailed, and around 300 in number. It will be necessary for us to gain assurance that all of these requirements have been met before we can decide to grant approval for a model’s use. We make no apology for doing so, since model approval is not something which should be granted lightly, and the Directive allows for no discretion in applying or not applying certain requirements. Model approval will allow firms to set their own pillar one regulatory capital requirement, something which is a step change both from the existing Directives and our own current ICAS regime. Once granted, it is difficult to unwind, and so we need to be sure that not only is the resulting capital requirement correct, but also that the framework of the model is sufficiently robust and risk-sensitive to respond to changes in circumstances over time.

  

 Proportionality

  

 What the Directive does allow for – and indeed specifically mandates – is the principle of proportionality. This means that the amount of effort which we and you collectively will have to go to in order to show that a requirement has been met should be commensurate with the risk that is posed by the item in question, and the extent to which it is material to the performance of the overall model. My commitment to you, therefore, is that our review work will focus on what is genuinely important in the context of your business, whilst bearing in mind our obligations under the Directive.

  

 The practical steps we have taken to ensure this have included senior management challenge of all of the workplans for pre-application, and the approach of reviewing teams will be challenged again at a number of stages through the process to ensure that we are focusing our efforts on what are the main drivers of risk in an individual firm.

  

 We make no apology, though, for being challenging in our approach to what firms are doing. I want to give you today some examples of specific issues which have arisen and why they are important. This will hopefully help to put into context some of the questions we are asking and the approach we have taken so far, and will continue to take.

  

 The first example is in the area of model scope, where we have challenged firms on their exclusion from scope of important factors which could be significant drivers of the model’s performance. One example of this is in the area of catastrophe modelling. Clearly if a firm has a significant portfolio of catastrophe-exposed business it is not a tenable position, as some have claimed, that catastrophe models are out of scope, as these will have a very significant effect on the way in which the model functions and the extent to which it is genuinely reflective of risk.

  

 The second issue that our review work regularly identifies is where various aspects of a firm’s model submission do not fit together in a coherent way. Let me give you an example. We do not view the Directive requirements in silos – Model Scope, Use Test, Validation, Model Change requirements are all linked and interdependent. In reviewing a firm’s model we therefore need to ensure the approach being taken to scope, use, validation and change are all consistent. And this will include the extent to which the senior management and Board of the firm have engaged with, understood, and challenged what has been done.

  

 The third is in the area of documentation. Our review work regularly highlights examples of firms being able to provide credible explanations of how certain Directive requirements will be met, but not necessarily being able to follow through with sound documentary evidence of this compliance. This does not necessarily mean that more documentation is required, simply that it needs to be of better quality. For the reasons I outlined earlier this is an important factor in being assured as to the performance of the model in a range of future circumstances.

  

 In some cases the state of documentation is a reflection of the fact that firms are implementing and embedding their models in parallel with the development work. We recognise what’s driving this issue and are sympathetic with the challenges that firms face in this regard but we will continue to view the quality of a firm’s documentation as being an important indicator of overall preparedness for making a submission.

 Whilst it is important for us to be robust, and I hope the foregoing examples give a sense of why this is the case, I would ask you to raise with your supervisor any concerns you may have about the approach which is being taken or the scope of our review. They will be able to explain what it is that the review teams are doing and why they are taking a certain approach or raising certain concerns.

  

 I should mention that we are also working to ensure that our approach is consistent with that taken by supervisors in other Member States. We are pursuing this through European Insurance and Occupational Pensions Authority (EIOPA), and also through more informal contacts with the supervisors in the other major jurisdictions. Through its peer review work EIOPA is currently reviewing Member States’ approaches to pre-application, and also the performance of a sample of colleges. We know that this is a matter of acute importance to many groups with European operations, and we will not be able to achieve our objectives without close cooperation with regulators in other parts of Europe. By seeking this consistency we also hope to achieve one of the other aims of the Directive, which is to achieve a high level of harmonisation across Europe.

 In mentioning this high level of harmonisation I would like to emphasise – as I have on a number of occasions in the past – that it is categorically not our intention to ‘gold plate’ the Directive’s requirements on model approval, or, for that matter, in other areas. We have designed our processes in accordance with a set of requirements which are derived directly from the Directive text. In the few areas where we have felt the need to do something which is different or in some way super-equivalent – for example in the area of approved persons – we have sought to be transparent about this in the text of our consultation documents, and have drawn our reasoning specifically to your attention.

  

 All of this, of course, is the FSA’s stated approach, but you may be wondering whether this will continue to hold true once responsibility for insurance regulation passes to the new Prudential Regulation Authority (PRA), probably in spring 2013. The simple answer to this is yes, it will, and the reasons for this are very simple. First, the senior management team responsible for Solvency II in the FSA are – by and large – the people who will continue to be responsible for it when we move to the PRA. Our colleagues from the Bank of England have been engaged in our implementation programme for over a year now, and are also fully aware of the approach we are taking.

  

 The second is that Solvency II seeks to bring into place a regime which is based on the same principles as that envisaged for the PRA. Solvency II is a regime which is forward-looking, based on a market-consistent valuation basis; it encompasses a proactive framework for supervisory intervention, and provides a direct link between risk and capital. All of this is completely consistent with the judgement-driven approach to supervision which the FSA and the Bank of England set out in the launch document for the PRA, which we published last summer.

  

 The third reason is derived from the second, namely that we are ensuring that the requirements of Solvency II are being taken fully into account in the design of insurance supervision in the PRA. This should ensure that the process you see being developed now will endure through the creation of the PRA and beyond, and supervision of insurers under the PRA will have at its core the requirements of the Solvency II Directive.