By Barney Wanstall, Director, Insurance, PwC and Twewah Marfo, PwC
You may ask what the Forth Bridge has to do with Solvency II. Well, The Forth Road Bridge is a long span suspension bridge which when opened in 1964 was the largest in the world outside of the United States. Both the Bridge and the SII Directive are undoubtedly enormous feats of human engineering. The problem with such gargantuan projects is that you can never fully future proof them; it is likely that no sooner have you completed the initial build than the maintenance programme must begin to address the rusty bits.
The Solvency I Directive 73/239/EEC, the predecessor to SII, was introduced in 1973. 43 years on SII has been implemented, after almost a decade of policy development, consultation and implementation at a cost to the European Insurance Industry of several billions of euros. Unlike the Forth Road Bridge it is unlikely that it will be another 20-25 years before some fundamental changes are called for.
There a number of areas which could be subject to calls for maintenance or reform. Some of the prime candidates are described below.
1. The Risk-free curve and Ultimate Forward Rate (UFR)
The curve which insurers use to discount their liabilities has been criticised by both the industry regulators for reasons including:
• The method of extrapolation between the last liquid point, which it is argued creates difficulties for insurers in relation to hedging;
• The UFR and the approach to adjusting the risk-free rate to address artificial volatility in assets which, it is argued, are not fully effective and impair the ability of insurers to invest in the economy.
2. Long Term Guarantee package
Linked to the UFR, the contents of the LTG package were the subject of extensive debate and negotiation, many will recall that the challenge, complexity and disagreement in this area is one of the main reasons Solvency II ended up being implemented more than 3 years after the original intended start date in 2012. It would be logical that after Solvency II has gone live and there is real market data and experience in this area that the LTG measures are subject to some form of review and revision.
3. Risk Margin
The risk margin is intended to reflect the cost of transferring insurance liabilities to an alternative insurer and is a new concept introduced by Solvency II. It has been criticised for a number of reasons including:
• The assumptions of the hypothecated market risk margin have been overtaken by developments in the real market which make it easier for insurers to transfer major risks which in the past were considered impossible to move (e.g. longevity reinsurance market);
• The assumption of a 6% of cost-of-capital above risk free is now considered much too high compared to the market today
4. Standard Formula asset charges
Despite recent amendments to the regulations, criticism of the 25% uniform capital charge on long-term assets under SII remain. These include:
• The charge is considered by many in the industry to be too high, creating an obstacle to investment by insurers in assets such as infrastructure;
• It is argued that the exclusion of corporates from the infrastructure investment definition
creates a barrier for investment in existing and potential projects.
There is now open discussion of a distinct infrastructure asset class to address these concerns. At the same time it would also seem likely that some of the other asset calibrations would also be reviewed, such as the Equity dampener.
More generally, the architects and overseers of Solvency II will be monitoring it to see whether it is meeting the original objectives.
This is likely to lead to a greater focus on areas such as Standard Formula appropriateness and overall market solvency to check that the Directive continues to be effective. Naturally these stakeholders will be more focussed on security and policyholder protection than the cost or difficulty with ongoing compliance. The industry will therefore need to be vocal on the latter - including pragmatic solutions - if it is to help develop the currently implemented image of the directive. Thus for the time being Solvency II looks set to be more like the original 1964 Forth Bridge than the 2011 version coated with long lasting and super durable epoxy glass flake paint.
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