Asia and Solvency II
In recent years, many Asian countries have adopted Risk-Based Capital regimes ("RBC") to regulate solvency of insurers. With the European Union’s proposed adoption of Solvency II, it is expected that more Asian regulators will adopt RBC systems.
WHAT IS THE CURRENT POSITION IN ASIA?
The levels of sophistication in the RBC regimes adopted vary between Asian regulators. Many regimes have similar elements as Pillar 1 of Solvency II (i.e., a solvency requirement). No Asian country has implemented a regime fully equivalent to Solvency II, other than Japan’s solvency regime for reinsurance.
Solvency requirement is based on a standard formula which requires the insurer to meet a 99.5% confidence level for one year. Singapore is still reviewing its RBC regime and the next phase will consider the use of internal models.
Singapore has introduced in 2013 Own Risk Solvency Assessment ("ORSA") and disclosure requirements. The first ORSA report for insurers is due 31 December 2014.
Malaysia implemented RBC in 2009 and uses a standard formula to assess solvency requirement. It has introduced ORSA requirements but not the disclosure requirements set out in Pillar 3 of Solvency II.
Solvency requirement is based on insurance risk, investment risk, minimum guarantee risk and third sector insurance (medical) risk. Japan also has a requirement for an appointed actuary to prepare an "Opinion Letter" on an annual basis, which sets out reserve adequacy, fairness of policyholder’s dividends and business continuity under some scenarios. This is somewhat short of the Pillar II ORSA requirements which require the insurer to undertake a forward-looking risk assessment and implementation of effective management practices to control and report on risk.
Japan’s regime for re-insurance has been found by the European Insurance and Occupational Pensions Authority to be equivalent to Solvency II.
Thailand implemented RBC in September 2011. The solvency requirement consists of insurance risk, credit risk and market risk, but not operational risk. Thailand has not introduced any ORSA or disclosure requirements.
China is still on a "first generation" solvency regime and has not adopted RBC. The China Insurance Regulatory Commission issued a new regulation in July 2012 requiring insurers to strengthen their solvency management focusing on four areas:
- Setting up solvency management;
- Preparing a capitalisation plan;
- Forecasting near-term solvency and preparing a remediation plan, if needed; and
- Establishing accountabilities.
Hong Kong is also on a "first generation" solvency regime but is considering adopting a RBC regime having commissioned a consultant to carry out a study on the framework for insurance business in Hong Kong in 2012. The regulator is aiming to consult the industry on the proposed framework later in 2013 and come up with a recommended framework early next year.
IMPLICATIONS OF SOLVENCY II ON ASIAN REGULATORS
Due to the anticipated implementation of Solvency II in the European Union, Asian regulators have been reviewing their solvency regulations with a view to focus more on risk. Countries with "first generation" solvency regimes are expected to move towards RBC regimes, although this may take some time as there will be lengthy consultations and discussions.
At this time, Asian regulators do not appear to have any plans to fully adopt Solvency II. However, Singapore’s and Malaysia’s regimes are already very similar to Solvency II. Singapore is also still reviewing its RBC regime with a view to adopting further elements of Solvency II (such as the internal model).
Asian regulators do not appear to have any difficulty in adopting and implementing Pillar I solvency requirements, but seem hesitant about the requirements for the other two Pillars, particularly the ORSA requirements in Pillar II. ORSA involves managerial skills in reviewing and adopting policies and internal practices to deal with the various risks faced by insurers, which would require Asian insurers to spend considerable time and money to fully acquaint their management and board; that will require greater technical expertise as some insurers have limited capability and resources to properly undertake the risk assessment and adopt appropriate managerial practices.
Solvency II has made Asian countries more aware of the importance of risk in assessing insurers’ solvency and to develop regulatory regimes which takes account of the full range of risks facing insurers. Given the economic and business development in Asia, it is important to develop robust solvency regulatory frameworks for the confidence of businesses and consumers.
UK – Financial Transaction Tax: What This Means For Insurers
On 14 February 2013, the European Commission adopted a proposal for a Council Directive for a financial transaction tax (the "FTT") to be introduced in a subset of the EU, Austria, Belgium, Estonia, France, Germany, Greece, Italy, Portugal, Slovakia, Slovenia and Spain (the "FTT Zone"), using the Enhanced Cooperation Procedure ("ECP")1.
The FTT is charged on both sides of a taxable financial transaction, which broadly includes transfers and exchanges of shares, bonds and other financial instruments, and derivatives contracts. The current proposal is for a minimum rate of 0.01% on derivatives, and 0.1% on other transactions. Liability primarily rests with financial institutions that are party to the financial transactions (whether on their own account or as an agent), and the definition of financial institution is very broad to include banks, funds and their managers (including pension funds), market-makers and insurers. Most controversially, the proposed FTT has an extraterritorial effect through the ‘issuance principal’, which states that the tax will be chargeable, regardless of the residence/ location of the contracting parties, where the underlying financial instrument is issued within the FTT Zone. Accordingly, despite the UK not being within the FTT Zone, this means that UK financial institutions will likely be affected by the FTT.
Although most insurance activities (including the writing of insurance and reinsurance) is not within the scope of the FTT, many investment activities undertaken by insurers will be. This is likely to have an impact on the profitability of investments held by insurers, who may be considering a number of behavioural changes in response to the FTT, such as:
- greater investment in Asia-Pacific or American investments (i.e. non-taxable), rather than FTT Zone investments;
- a reduced volume of financial transactions, possibly through increased holdings in longer-term (‘buy-to-hold’) investments; and/or
- a shift toward non-taxable investments such as property, rather than financial investments.
The UK issued a legal challenge questioning the legality of use of the ECP to implement the FTT on 19 April 2013. In addition, there has recently been much speculation about whether the FTT will proceed as currently proposed, or whether any FTT actually enforced will be ‘watered-down’. One of the most ambitious aspects of the current proposal is its timing, with the FTT due to go into effect as of 1 January 2014. This seems highly unlikely given the current progress of negotiations, and a number of other factors (including the German elections in September 2013). Certain commentators have speculated on the possibility that the FTT will be introduced with lower rates than currently proposed, or with a reduced scope of taxable financial transactions or financial institutions. A number of insurers have remarked that there is still too much uncertainty around the FTT to predict what specific impact it will have on their business, but it is clear that insurers will need to be prepared for the FTT.
UK – Solvency II Update: EIOPA Report on Long-Term Guarantees Assessment
On 14 June 2013, the European Insurance and Occupational Pensions Authority (EIOPA) published its report on the impact of the long-term guarantees package contained in the Solvency II Directive. EIOPA carried out a technical assessment of this package following a request from the trialogue parties, the European Parliament, European Commission and European Council.
In a press release, EIOPA commented that the final package to be included in Solvency II should fulfil the following principles:
- alignment with the Solvency II framework and the economic balance sheet concept;
- full consistency across EU member states to enhance the single market;
- efficient linking of all three pillars (quantitative basis, qualitative requirements and enhanced reporting and disclosure);
- proportionality and simplicity; and
- adequate treatment of the transitional issues.
EIOPA has suggested that if these principles are fulfilled, the package will ensure a high degree of policyholder protection, appropriate risk management incentives and an effective supervisory process.
Now that the EIOPA report has been published, it is expected the Commission can begin its response and formal negotiations. However, some commentators have been less optimistic about the impact of the report, suggesting that it has not offered an end to the dispute surrounding long-term guarantees, but rather the report will simply lead to further studies before any final decisions are made.
UK – FCA Publishes Its Report on Motor Legal Expenses Insurance ("MLEI")
On 7 June 2013, the Financial Conduct Authority ("FCA") published its report on MLEI after increased regulator scrutiny into the ‘add-on’ insurance market. MLEI is an add-on to a motor insurance policy and it is most commonly sold on an opt-out basis. The FCA has called on providers of MLEI to consider the basis on which the cover is sold, the quality of the explanations around the product (at all stages of the customer journey) and the extent of the coverage offered. In particular, the FCA has focused on the ‘opt-out’ nature of MLEI and has recommended that customers ought to be able to opt-into buying MLEI products. The FCA has highlighted that some consumers lack the confidence to deselect MLEI when it has been pre-selected by the provider.
One other area of concern highlighted by the FCA is the issue that most policy wordings contain long, legalistic terms that make it hard for the consumer to understand what they are purchasing. Also, the FCA noted that the most important elements of the policy wording are often given insufficient prominence. The FCA has emphasised that providers should seek to provide clear and appropriate information to consumers. In particular, the FCA recorded that the most common deficiency was a failure to make it clear that the uninsured loss recovery element of the policy only operates when the policyholder is not at fault for the motor accident.
Simon Green, the head of insurance and protection at the FCA, has commented that firms that fail to comply should expect a ‘proportionate approach’ from the regulator and the FCA will revisit this issue within a year. The regulator expects insurance firms to be able to give a clear account of the nature of the review they have undertaken into MLEI and the reasoning for any decisions made, especially if the decision is not in line with the general industry, for example, the retention of opt-out selling.
The Association of British Insurers ("ABI") has commented that the report acts as a useful reminder that more must be done to meet the needs of the consumer. This comment is particularly on point given that the FCA has questioned whether firms are motivated by generating revenue as opposed to meeting consumer need.
US – NAIC Captive and Special Purpose Vehicle Use (E) Subgroup Adopts White Paper
On June 6, 2013, the National Association of Insurance Commissioners ("NAIC") Captive and Special Purpose Vehicle Use (E) Subgroup (the "NAIC Captives Subgroup") finalized and adopted a revised version of its White Paper on Captives and Special Purpose Vehicles ("SPVs"). The NAIC Captives Subgroup made only minor revisions to the March 14, 2013 draft White Paper, deleting the statement "Due to changes made to AG 38 by NAIC in 2012, the creation of new captives and SPVs should no longer be needed for such financing transactions." The deletion was made in response to industry comments pointing out that this is not necessarily the case.
The adopted White Paper’s recommendations point to the need for further information gathering and analysis rather than immediate legislative action regarding the use of affiliate captive reinsurance transactions. The paper will now go to the NAIC Captives Subgroup’s parent committee, the Financial Condition (E) Committee, to determine what action, if any, the NAIC will take to implement the Subgroup’s recommendations. The Subgroup also formally asked the Blanks (E) Working Group to consider implementing enhanced disclosure of affiliate captive transaction in statutory reporting.
US – New York Issues Report on Use of Captives
On June 12, 2013, the New York Department of Financial Services ("NY DFS") issued a report titled "Shining a Light on Shadow Insurance: A Little-known Loophole That Puts Insurance Policyholders and Taxpayers at Greater Risk". The report can be found here.
The report sets forth findings of the NY DFS based on its investigation that was commenced in July 2012 regarding use by insurance companies of captive reinsurance transactions, which the NY DFS refers to as "shadow insurance to shift blocks of insurance policy claims to special entities [captives] in order to take advantage of looser reserve and regulatory requirements". Among the report’s conclusions are that the use of captive transactions "does not actually transfer the risk for those insurance policies because, in many instances, the parent company is ultimately still on the hook for paying claims if the shell company’s weaker reserves are exhausted", such transactions could "put the stability of the broader financial system at greater risk", and they "could leave insurance companies on the hook for losses at their more weakly capitalized shell companies". The NY DFS report includes various recommendations, including a call for greater disclosure and transparency about the use of captives and an "immediate national moratorium" on such transactions.
However, insurance industry representatives and other regulators have questioned the conclusions and recommendations in the NY DFS report by noting, inter alia, that such captive transactions are already subject to regulatory scrutiny and reporting and are in any case already being considered by regulators such as by the NAIC Captives Subgroup.
US – FACI Task Force to Examine Captives
In addition to the ongoing consideration of the use of captives by the NAIC, NY DFS and other regulators, earlier this year the director of the Federal Insurance Office ("FIO"), Michael McRaith, called for the creation of a task force under the Federal Advisory Committee on Insurance ("FACI") to examine captives and SPVs. Some FACI members have argued that such an undertaking is unnecessary because the NAIC is already conducting such a review through its NAIC Captives Subgroup. However, McRaith has stated that a federal task force is necessary to keep the US Treasury Department "fully informed" on the risks associated with the use of captives. Supporters of the task force believe it will help draw attention to the potential issues with captives and push the NAIC to follow through on its recommendations.
US – FIO Releases First Annual Industry Report
The FIO issued its first annual report on the state of the US insurance sector on June 12, 2012. The report can be found here.
The report provides an overview of the US insurance industry’s financial health, legal and regulatory changes, and trending issues. In the report, the FIO cites the record aggregate premium and surplus figures as evidence of the industry’s rebound from the global financial crisis. The report notes that insurers showed growing profitability in 2012 after experiencing heavy losses in the post-2008 economy, though company market values have yet to recover fully.
With respect to the regulatory environment, the FIO report discusses work done both domestically and internationally by organizations like the Financial Stability Oversight Council and the International Association of Insurance Supervisors (the "IAIS"), such as the ongoing work of IAIS in developing a system for the identification of "global systemically important insurers."
In discussing current issues, the FIO report points out the recent effects of low interest rates and natural catastrophes on the industry’s operation. The FIO report also mentions upcoming industry trends, including changing demographics in the US and opportunities for growth in emerging markets.
On June 13, 2013, the FIO Director, Michael McRaith, stated before the US House Financial Services Subcommittee on Housing and Insurance that the FIO will publish additional reports before the end of the year, including a long-awaited report on modernizing regulation of the US insurance industry that was mandated by the Dodd-Frank Act and was scheduled to be delivered to Congress in January 2012.
US – NAIC Reviews Acquisitions in the Insurance Industry by Private Equity Firms and Hedge Funds
The NAIC Financial Analysis (E) Working Group ("FAWG") is responsible for (i) evaluating insurers that are trending downward or demonstrating financial troubles and (ii) aiding multi-state efforts to prevent or limit solvency issues within the insurance industry. On May 6, 2013, FAWG presented a memo to the NAIC Financial Condition (E) Committee regarding increased interest in the insurance industry by private equity firms and hedge fund managers, especially with respect to life insurance companies and annuities businesses. The memo states that "[c]ontrol over annuities, either through acquisition or through a reinsurance agreement, provides the firms the opportunity to manage the assets of the insurer." The memo also states that some FAWG members are concerned that the interests of private equity and hedge fund investors are not necessarily aligned with the interests of policyholders because insurers need to consider a long-term horizon to cover future policy benefits and limit unnecessary risks for their policyholders but that such "use of prudence is inconsistent with the business model of private equity firms and therefore creates inherent risks".
To monitor and reduce these risks, the memo proposes certain "best practices" for possible inclusion in the Financial Condition Examiners Handbook and Financial Analysis Handbook. The FAWG proposals include changes to the criteria used to evaluate "Form A" change of control applications, including requiring investors to demonstrate that policyholders will be fundamentally more secure after the change of control. New elements of the "Form A" review could include scrutinizing the acquiring entity’s investment strategy, having specialists review the proposed transaction and investment fee structure, requiring pro formas for specific stress scenarios, and requiring the acquirer to provide a capital maintenance undertaking. In terms of post-acquisition monitoring, the FAWG memo suggests procedures for annual targeted examinations of insurers and their affiliates, targeted examinations of non-affiliated insurers that have ceded a material portion of their annuity risk to a private equity-controlled insurer and coordination with international regulators when a non-US entity is involved. The FAWG memo notes that these new procedures may require changes to the Credit for Reinsurance Model Law, the Risk-Based Capital Formula, and various state investment laws. FAWG has recommended to the Financial Condition (E) Committee that a new NAIC working group be formed to develop procedures that regulators can use when considering ways to mitigate or monitor these risks from private equity and hedge fund investors in the insurance industry.
The FAWG memo was received by the Financial Condition (E) Committee and is being exposed for comments through early July. Following the comment period, the committee will meet to discuss taking further action, such as potentially forming a new working group.