Summary
Participants:
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- European Commission (EC): Filip Zrile (Policy Officer, Insurance and Pensions), Marc Horovitz (Policy Officer, Insurance and Pensions)
- Industry: Laurent Cholvy (AXA), Olav Jones (Insurance Europe), Carolien Afslag (Insurance Europe), Jelle Ritzerveld (Aegon – by call), Ben Carr (Aviva – by call), Niall Kavanagh (Scor – by call), Kristina Alexandrova (Insurance Europe – by call)
On 26 July, the secretariat of IE met with the EC technical experts (DG FISMA) to discuss in more detail the industry’s concerns regarding the cost of capital under Solvency II, following a joint industry paper shared with the EC on the cost of capital, which explained the flaws in the EIOPA analysis. The meeting came as a follow-up to a meeting between the EC and the Industry on 13 July.
The industry delegation highlighted that in their responses to the consultation on EIOPA’s draft advice the CFO Forum and Insurance Europe raised a wider set of issues and concerns with the methodology and calibration of the Risk Margin. However, in the paper sent more recently to the Commission the focus was not to challenge EIOPA’s method, but rather to follow their chosen approach and explain a number of flaws which when corrected would lead to a different recommendation.
They asked whether the paper was shared and/or discussed with EIOPA. The industry delegation noted this was not the case, but highlighted that all arguments discussed in the paper were raised in the responses from the CFO/CROF and Insurance Europe to the consultation paper on EIOPA’s second set of Advice but that EIOPA had not given good reasons to reject the industry’s points.
The key points were summarised and each was discussed in turn:
1. EIOPA states that the reference entity is 100% equity funded, but EIOPA uses betas from companies that have leverage – therefore by not seeking to deleverage the beta’s EIOPA is being inconsistent.
2. The Solvency II regulation requires market risk within the reference entity to be minimised, but EIOPA did not make a correction to the input data to reflect this requirement. This is again inconsistent.
3. EIOPA’s equity risk premium (ERP) is not consistent with the Solvency II Regulation (to use a forward- looking ERP) and ignores the expert opinions from available academic studies who all recommend lower ERPs.
On the first point. The EC experts noted that it is not correct to state that EIOPA assumes that the reference undertaking is 100% equity funded. EIOPA makes an assumption for the purpose of simplicity that the debt can be assumed to be zero based on their data that that total non-Tier 1 capital was only 6% for the industry.
The industry delegation noted that this is not correct for two reasons: the 6-8% is not the market leverage that affects betas, but it is the ratio of debt instruments recognised by Solvency II. In order to determine beta, the market does not look at regulatory leverage, but at economic leverage. Also and more importantly, EIOPA uses the beta based on a sample of companies with an actual leverage (EIOPA itself gives in the report) of 23% and therefore it is clear that they cannot use the beta from these companies and apply it to a reference entity assumed to have no leverage without adjustment. 2
The EC experts also noted that the reference undertaking has 100% coverage ratio whereas sample of insurers have much higher coverage ratio and this effect might offset the impact of using a levered rather than unlevered beta, although they recognised that EIOPA had not raised this point. The industry delegation noted that this would be a separate discussion. However, as the reference undertaking is a run-off type of vehicle, it is not clear why a run-off vehicle would need anything other than 100% solvency, while it is clear why normal insurers that wanted to generate and fund new business and growth would want a higher ratio. And conversely, the capital mobilized by a run-off would be minimized.
The EC experts appeared to acknowledge that an adjustment for leverage to the beta could be made, but remained convinced the 100% ratio would increase the cost of capital by increasing the beta of the reference undertaking relative to the sample of insurers used by EIOPA although they acknowledged that EIOPA had not made this argument themselves. The EC experts also argued that one cannot pick an element and ignore the possible interactions, as this would be artificial. The industry delegation noted that the paper remained within the remits of EIOPA’s analysis and highlighted that the concept was a prudential creation/construction based on the idea of a specific reference undertaking.
On the second point, the Commission appeared at first not to be convinced that the reference entity should have no market risk as this was not crystal clear in the legal texts. When it was pointed out that considering only non-hedgeable risks was a core part of the whole risk margin theory and methodology they agreed but remained unconvinced that this should necessarily impact both capital projections and the cost of capital. They pointed out that if true this could imply a zero beta. The industry delegation agreed that indeed in theory this could be true but in practice there would remain most likely linkages to the market, it also makes clear that the assumption of only a 10% reduction to account for the minimisation of market risk was a very conservative one. The market risks represent the largest part of the SCR of insurance undertakings. The industry delegation also reminded the EC experts about Art. 38(1) (h) of delegated acts which specifies that the assets are selected in such a way that they minimise the Solvency Capital Requirement for market risk that the reference undertaking is exposed to – a requirement that cannot be ignored.
They did not acknowledge a correction was needed but indicated they would review the original CEIOPS papers on Risk Margin to see if that would provide further clarification.
On the third point, the Commission said they shared EIOPA’s concern that a forward-looking approach was too sensitive to inputs and that some experts appeared to support a historic average based on arithmetic rather that geometric means. They also however indicated that they thought EIOPA may have in fact used a forward- looking approach based on Damodaran’s preferred methodology and may have included a table based on his method in their historic data section and also used this data in their final recommendation. The industry delegation noted they thought this this was not the case but would check.
The industry delegation pointed out that irrespective of the details, all experts advised on a lower ERP than EIOPA and that this should not have been ignored by EIOPA in their final advice. The industry delegation also mentioned that it supported the geometric average because it captures better the compounding of returns. The delegation asked the EC experts whether their remark about EIOPA having used “by mistake” a forward-looking approach – which the industry defends – meant that they agreed that a forward-looking approach was more appropriate – the EC experts did not reply and then developed by arguing on the more stable dimension of historical series.
Finally, disappointingly, despite a good discussion on the points and an indication in certain areas they agreed had some valid points, in particular on the second point on the correction of the beta for minimal market risk the EC experts seemed more receptive. The Commission summed by saying they considered EIOPA’s work good enough overall and there was not sufficient evidence to justify a change.