1 January 1970

Equivalent not equivalent-- shaping the outcome of group supervision

Why group supervision is important

Group supervision aims to protect regulated insurance companies from the risks associated with being part of a group. Indeed, the financial crisis has demonstrated the far-reaching implications when group risk is not understood or controlled. Consequently, both the G20 and IAIS advocate not only risk-based regimes, but ones in which group risk is an essential component of solo supervision.

Without doubt, Solvency II is at the forefront of developing regulation, recognising the international nature of European insurers and reinsurers, and constructing its supervisory regime accordingly. In so doing, Solvency II introduces group supervision at a worldwide level and, to facilitate this, the concept of equivalence.

The real impact of equivalence

It is often reported that equivalence has the potential to dislocate the global insurance market, and there is speculation that recent restructuring and redomestication activity may be attributed to equivalency concerns.

This is not the intention, and arguably not the reality. Equivalence reflects recognition on the part of the European Commission that, in fully considering the risk posed to European re/insurers, the supervisor’s ‘review’ necessarily straddles regulatory boundaries. The primary purpose of equivalence, is to enable recognition of other regulators’ regimes and, through this, to facilitate effective, efficient supervision.

Solvency II identifies three areas where equivalence is relevant. It is possible for regulatory regimes to be assessed individually with respect to each area.

Reinsurance equivalence: Where a European re/insurer reinsures to a non-European reinsurer. Reinsurance equivalence has two impacts: for the cedant, the treatment of the reinsurance within its solvency capital requirement; and for the reinsurer, the possible imposition of collateral requirements. Since counterparty credit default risk is determined, firstly, by reference to rating, there should be no impact on cedants whose reinsurance is with an internationally rated reinsurer. Since European supervisors are required to treat an equivalent reinsurer on a consistent basis to a European reinsurer, for non-European reinsurers, equivalence removes all possibility of collateral being imposed within Europe.

Equivalence of third-country re/insurer for group solvency purposes: Where a non-European re/insurer is part of a group that is subject to Solvency II group supervision. If group solvency is determined using the deduction and aggregation method, this element of equivalence enables the equivalent local solvency assessment basis to be used, rather than requiring computation on a Solvency II basis.

Group supervision equivalence: Where a European re/insurer is part of a non-European group. Here, equivalence seeks to rely on the group supervisor’s regime beyond the European border, rather than impose Solvency II requirements on the worldwide group in the assessment of group risk.

Equivalence therefore provides a degree of regulatory certainty, and removes the scope for compliance duplication and for supervisory intervention in market practice—for example, through the imposition of reinsurance collateral arrangements.

In the absence of equivalence, the impact will vary according to specific circumstances, with each aspect of equivalence having different business implications. It is vital that non-European re/insurers consider the implications for them and the most appropriate mechanism to manage the uncertainty that non-equivalence presents.

Here we consider the implications of group supervision equivalence.

What does group supervision entail?

Group supervision under Solvency II is essentially a supervisory tool kit aimed at helping European supervisors assess the risk that membership of a group brings to European policyholders. Through requiring groups to comply with significant components of the solo supervision regime, Solvency II provides the European supervisor with sufficient information to assess this. The requirements include:

• A group solvency calculation, including eligible capital requirements

• A group Own Risk and Solvency Assessment

• Group disclosure and supervisory reporting

• Reporting of group risk concentrations and intra-group transactions

• Requirements relating to group governance and risk management.

In addition, Solvency II introduces the concept of a group supervisor, appointing a European group supervisor to lead the supervision of the European group and to assess the management of worldwide group risk to the European business. In so doing, the various European supervisors’ perspectives are taken into account through the operation of a supervisory college.

At what levels does group supervision apply?

Group supervision is triggered by the presence of an insurance group, and Solvency II cites a range of circumstances where this may arise. These can be summarised as applying where a European re/insurer:

• Owns another re/insurer, and/or

• Is owned by an insurance holding company and/or a mixed activity holding company.

Group supervision applies at all of the above levels, irrespective of whether the parental ownership exists within or outside Europe. For a non-European insurance or mixed activity group, where there is also a European insurance holding company, the group supervision requirements operate at both European and worldwide level.

How does equivalence affect non-European groups

Group supervision under Solvency II potentially has different compliance implications for non-European groups, depending on equivalence. However, the intended supervisory outcome is the same, regardless of equivalence—the assessment of risks to European policyholders. Rather, it is the means through which this is achieved that equivalence impacts.

Equivalent group supervisor: Where the worldwide group is subject to an equivalent group supervisory regime, the European supervisor is responsible for the supervision of the European subgroup under the Solvency II regime. Beyond the European border, European supervisors will rely on the equivalent group supervisor’s regime, and group risk to the European business will be discussed through supervisory co-operation and engagement with the business.

Non-equivalent group supervision: Where the overseas regime is not recognised as equivalent, the European supervisor retains the right todetermine the information to assess worldwide group risk in relation to the European business. There are options regarding the approach, which include the ability to impose the requirements of Solvency II’s group supervision regime in full to the worldwide group. The European supervisor may deem that the risks to the European policyholders are best mitigated through requiring the insertion of a European holding company to clarify ownership and better ringfence European entities.

The European supervisor’s intervention powers do not, however, extend beyond the European border, and the ambition under Solvency II is not for the European supervisor to be the de facto worldwide group supervisor. The group supervision requirements are firmly directed to determining the impact of worldwide group risk on the European business.

Where there is no equivalent group supervision regime, Solvency II allows the European supervisor to use ‘alternative methods’ through which to perform the worldwide group risk assessment, rather than impose the Solvency II group supervision requirements in full. Policy in this area is still developing, but key to this, and the European supervisor’s information requirements, will be the specific circumstances of the group. For example, the sophistication and maturity of its risk and capital management arrangements, the extent and nature of intra-group relationships, and the group and capital structure will all influence the supervisory approach. The ability of the group to demonstrate to the European supervisor’s satisfaction, effective identification, monitoring and management of group risk to the European entities will be key.

It will therefore be advantageous for those groups with advanced business risk processes and an effective structure to explain their approach to the European supervisors. These groups may wish their case for the group supervision to be based around the group’s own business-driven internal risk management information, rather than requiring the full ambit of the Solvency II group supervision regime to be applied.

Practical implications for Bermuda groups

There are a number of perspectives for Bermuda groups to consider:

• Is the current group structure an enabler to group supervision or does it create additional issues?

• To what extent is the group already internally managing and evidencing its group risk and solvency capital, and does this cascade to individual entity group risk assessments? How aligned in its ambition and how credible is the group governance and risk framework in comparison to Solvency II? Will the group’s procedures allow a proper assessment of group risk when viewed through the European supervisory lens?

• How solvent is the group on a Solvency II basis? Is the group capital eligible and available to meet the capital requirements of the wider group?

• How effective is the group management information in addressing Solvency II issues—will this support the disclosure requirements?

Immediate actions for Bermuda groups

Given the Bermuda Monetary Authority’s (BMA’s) ambition to introduce equivalent group supervision, it will be essential for Bermuda groups to understand both the BMA’s and European supervisors’ needs. This will be imperative for planning purposes—to manage the uncertainty around the timing of equivalence assessments and to ensure a smooth transition.

The approach will necessarily be a bespoke one, matched to the specific circumstances of the group. Early consideration, engagement and collaboration with the respective supervisors will be key, both to shape the outcome and to ensure credit is taken for existing risk and capital management activities, and also to align supervisory approaches with the group business risk ambition.

Equivalence—a life-threatening challenge or a ‘nice to have’?

Solvency II’s group supervision regime presents many challenges for all groups, not just those headquartered outside Europe. For non-European groups, whilst the equivalence of group supervision undoubtedly brings clarity, non-equivalence is not of itself life threatening. Indeed, the flexibility in approach for non-equivalent regimes offers, in some ways, a less rigid application and greater scope for a bespoke approach. Successful groups will be those that are forward-looking and that, through their own internal procedures, effectively manage and monitor group risk, and can demonstrate to their respective supervisors the impact of this at insurance-entity level. In this, equivalence plays no role and groups must therefore take responsibility for their own destiny.

Richard Lightowler is head of insurance at KPMG in Bermuda. He can be contacted at: richard.lightowler@kpmg.bm

Jane Portas is a director at KPMG in the UK. She can be contacted at: jane.portas@kpmg.co.uk