Solvency II will, for most insurance assets (but not unit linked assets) replace set rules on admissibility and counterparty/asset exposures with a principles based test, known as the 'prudent person principle'.
2. What is the prudent person principle?
The prudent person principle requires insurers to invest their assets held for regulatory purposes (e.g. to cover expected liabilities and capital requirements) so as to ensure the security, quality, liquidity and profitability of their portfolio as a whole, which includes the need to be adequately diversified. Insurers also need to ensure that assets are localised so as to ensure their availability.
3. Best interest of policyholders
Assets held by insurers to cover their insurance liabilities (known as "technical provisions") must be invested in the 'best interests' of policyholders. This will be a new requirement and insurers are likely to need further guidance to understand its implications. It may, however, affect an insurer’s ability to invest in strategic assets or group companies and it seems likely that it could involve a lower degree of risk being taken with such assets (e.g. as opposed to those held to cover capital requirements).
4. Duration and matching
One of the aims of Solvency II is to encourage insurers to match their investments (and capital) more closely to their liabilities. They will suffer an additional capital charge if they fail to do so. This means that insurers will need an asset-liability management (ALM) policy. This will seek to match liabilities, which can themselves vary both in terms of amount and timing, with appropriate investments. One of the key elements of asset liability management is the time horizon over which the business is managed. The investment strategy needs to cover the potentially different timeframes and related risks. EIOPA has stressed the importance of continuing liaison between the different areas of the business involved in ALM and the need for appropriate tools to assess and take into account the inter relation between different types of risk.
5. Control and monitoring of investments
Insurers will need to ensure that they only invest in assets where they can properly understand, identify, measure, monitor and control the risks. In practice, as many insurers outsource some or all of their investment management, this means they will need to impose appropriate controls and ongoing obligations on their investment managers. Investment managers may also need special procedures for ALM policy compliance. This is likely to require a change to current investment mandates and investment management agreements, not least to remove reliance on the current rules on admissibility and counterparty/asset limits. Insurers will need to set their own limits on counterparty and asset exposures and to develop valuation models for complex or potentially illiquid investments. Investment managers may need to comply with, or provide input to such arrangements or models.
6. Unit Linked Funds
The exception to the prudent person principle is that more detailed rules can continue to apply where the policyholder is an individual taking the investment risk of a product. The FSA (prior to legal cutover in April 2013) had stated that it intended to retain its rules, known as the permitted links rules, in such cases. To comply with the terms of the directive, the current permitted links rules will be amended to make sure that they are no more onerous than the rules applying to UCITS.
7. Reporting of Assets
The prudent person principle also requires that insurers are able properly to report their assets. The final rules have not yet been agreed but systemically important insurers (e.g. 20 per cent market share) are likely to have to report their assets on a line by line basis. Whilst this will not apply to most insurers, all insurers will need to ensure that any outsourced service providers are able to meet the new reporting requirements so that they can consolidate information relating to assets held.
8. Effect on capital requirements
The main Solvency II capital requirement, the Solvency Capital Requirement (SCR) is a risk based capital requirement. This means that the risks inherent in the assets held by an insurer are taken into account in assessing its capital requirement. Some, mainly larger firms, will calculate the SCR (or part of it) using an internal model approved by their regulator. Everyone else will need to use a standard formula prescribed by the directive. This effectively imposes risk charges based on the amount at risk. So, for example, under one draft of the rules equity holdings could be subject to a risk charge of up to 59 per cent. The risk charge for exposures to debt vary depending on the duration of the debt and the rating of the counterparty. The risk charge for exposures to property assumes an instantaneous 25 per cent reduction in the value of the property. In addition, as part of the risk management (ORSA) process, insurers must assess whether their own risks in relation to investments are adequately covered by the standard formula.
9. Mind the gap
At the same time as Solvency II is introducing its new regime, banks appear to be less keen on long term arrangements which potentially tie up their capital. As long term insurers have long term liabilities which they need to match, they may be well placed to make longer term loans, particularly if they are secured on property (e.g. commercial lending).
The prudent person principle requires that unlisted investments be kept to a prudent amount and that derivatives be used only for reduction of risk or efficient portfolio management. This is essentially the same test as currently applies to insurers. However, it seems likely that there will be Level 3 guidance as to the meaning of these terms because it is understood that they are currently interpreted differently in other member states. It is also anticipated that in future derivatives will be used more to "mitigate" insurance and non insurance exposures in particular as part of the ALM strategy.