Navigating a course between Europe and the US

Chris Finney, partner in the insurance and reinsurance department of law firm Edwards Wildman, addresses the challenges associated with delays to Solvency II and the systemic risks inherent in a decreed regulatory regime.

What are the major challenges associated with delays to Solvency II?

One of the major issues among those who are involved with Solvency II is implementation fatigue. When Solvency II was first conceived, the industry was quite enthusiastic about its potential. Proponents saw it as an opportunity to reconfigure their business and have all the tools to hand to understand what is and isn’t profitable within the business— going through it all with a searchlight. Advocates realised that if their implementation of Solvency II went well, it could potentially give them a competitive advantage over other firms, especially as Solvency II would encourage more intelligent use of capital and resources.

However as implementation has dragged on, people have found it more and more difficult to keep their businesses engaged with the new regime. The industry is increasingly fed up with the shifting ground and it is becoming more difficult to retain senior team members associated with implementation, as a result. As the projecthas been repeatedly delayed, it has become more and more difficult to get management buy-in for the changes the business needs to make to comply with Solvency II from day one. You mention Solvency II these days and people roll their eyes and talk about something else. And I am not sure people are always joking when they ask: ‘do you think it will happen?’. I think it will, but the question is being asked seriously because implementation keeps slipping.

This implementation fatigue will only really be overcome when Europe fixes a clear and credible implementation deadline, and that deadline is near. Unfortunately, the constant re-phasing is getting in the way. Every time the implementation deadline is put back, or the European Union fails to reach a key Solvency II development milestone, people worry about how much more it is going to cost to achieve implementation, and they start to give up. As a result, Solvency II is becoming an increasingly Sisyphean task, and Europe is doing little to bring this perception to a clear and certain end.

How significant a challenge is making group structures Solvency II-compliant?

Within Solvency II, three different sorts of equivalence are envisaged. One is around reinsurance and the other two are around groups.

On the reinsurance issue, if you are a European insurer and you buy your reinsurance from a company based outside the EU, you will be able to take full credit for your reinsurance only if the third country has a Solvency II equivalent regulatory regime for reinsurers. If it doesn’t, you won’t be able to take full credit for your reinsurance, unless collateral or some other arrangements are put in place that will allow your regulator to be comfortable that you will be able to rely on the reinsurance if you need to. The assumption is that if your reinsurer is European, everything will be fine; if your reinsurer isn’t European, it might not be. This could make it more difficult for reinsurers domiciled in third countries that are not Solvency II equivalent to compete with European reinsurers, and Solvency II equivalent third country reinsurers, than it is at the moment.

If you have a parent or subsidiary outside the EU, equivalence issues also arise.

If a European re/insurance is owned by a third country re/insurance, the European re/insurance’s regulator will have to decide how to regulate the re/insurance group the two companies have created. If the parent is in a third country that is Solvency II equivalent, the European re/insurance’s regulator will be expected to rely on the parent’s localregulator to supervise the group. If it isn’t, the European regulator will have to decide how to supervise the group from Europe. And that might mean making the European re/insurance responsible for calculating the group’s capital requirements and making sure they are met.

If a European re/insurance has a third country subsidiary, there will also be a question about which rules are to be used to calculate the subsidiary’s assets, liabilities and capital requirements for group capital purposes. In some cases, if the third country is not Solvency II equivalent, the capital position of the third country re/insurance will have to be calculated under local rules, to make sure it meets its local obligations; but it will also have to be calculated under Solvency II, so the European re/insurance can calculate the group’s Solvency II capital requirements and make sure they are met as well. In many cases, the Solvency II calculation will generate higher capital requirements, and the group and its third country subsidiary will have to hold more capital than the subsidiary’s local rules require. For some groups, the answer to higher capital requirements is to sell the third country subsidiary. Several international groups are already looking to offload their US subsidiaries for these (and other) reasons.

Is there a danger that Solvency II could create systemic risks for the industry?

"Much like Solvency II in Europe, Dodd-Frank is so complicated as a regulation in the US that by complying with one rule you are potentially going to be in violation of another."

I think the answer is yes. Some European regulators are using Solvency II as an excuse—or interpreting it as though it requires them—to force the subsidiarisation of branches of non-EU reinsurance companies. If you are an American reinsurer with a branch in London, the Financial Services Authority (FSA) might say that Solvency II requires it to force you to turn your UK branch into a subsidiary, and to operate and capitalise it on a Solvency II basis. If the FSA or another European regulator did that, potential systemic risk issues would arise because reinsurance risks that used to be dispersed across the international reinsurance markets will now be concentrated in the EU. At the same time, the new EU subsidiary reinsurers will be smaller, less well capitalised and perhaps less well rated than the reinsurer they were once part of. That could also mean that they will be less robust if a crisis hits, and perhaps less likely to be able to meet reinsurance claims as they fall due.

Another possibility is that although Solvency II does not require re/ insurers to sell or invest in particular assets, the capital weightings and other requirements that sit within it encourage reinsurers to drop some assets and invest in others. That could be so significant that, rather than meeting the Solvency II objective of reflecting the valueof assets in the markets, Solvency II inadvertently begins to change the markets. For example, reinsurers may be much less inclined under Solvency II to invest in commercial property than they are today, and much more inclined to invest in shorter-term, highly rated commercial bonds or sovereign debt, and that could artificially lower property values and raise corporate bond values and lower yields because reinsurers are such enormous investors in these assets.

Barry Leigh Weissman, partner in the insurance and reinsurance department of Edwards Wildman, discusses how the Neal Bill and Dodd-Frank are playing out and addresses the challenges they may create for re/insurers.

How significant a threat is the Neal Bill to Bermuda reinsurers?

If the Neal Bill [which is aimed at ending a tax ‘loophole’ that allows US reinsurers to transfer premium income to offshore affiliates to reduce the tax on profits] were to pass it would have a significant impact on all offshore domiciles. I am a little sceptical that it will, however, and believe that if it does, then it will not pass in its present form. Granted, it is an election year and anything is possible, but personally I would be surprised because the economic implications for US firms and the international ramifications for relations with other jurisdictions would be considerable. It could potentially run foul of fair trade laws. The Neal Bill would also have a major impact on recent moves to reduce collateral requirements in a number of states, which have sought to strengthen their links with international reinsurers.

How can the industry head off the bill?

It should be the role of local US insurers to outline exactly why offshore reinsurers are so important to their businesses. Bermuda and other offshore jurisdictions obviously have to play their part in the debate, but I think that it is really more up to the US companies to explain why they need to set their businesses up in the manner that they do. If US companies rely just upon the tax benefits, then that may be a problem-- as that seems to be the focus of the bill-- but if they can convince government of the commercial benefits of their relationships, their argument will be enhanced. Matters are likely to be further complicated by the Solvency II project in Europe, which will create still further challenges regarding where a company locates its business and the amounts of security that will need to be posted.

What are the implications of Dodd-Frank for foreign reinsurers? Would it be possible for foreign reinsurers or even markets to be deemed systemically significant?

The way the statute is written it is focused on US companies. It would be surprising to see non-US holding companies deemed systemically significant. To deem a country systemically significant would be outside the scope of what the law is supposed to do as I understand it. That said, you have non-US based companies such as Swiss Re and Munich Re that have US entities and there is a possibility that there could be an effort to bring them within the systemic remit.

The focus instead will be on US insurers such as AIG. But I think that this focus is inappropriate because the insurance segment of AIG was actually solid, and still is. What is likely however is that regulators will take a closer look at all elements of the holding company, not simply those parts involved in insurance.

What are some of the challenges associated with the implementation of Dodd-Frank?

The Federal Insurance Office needs to come out with its report, but I suspect that with it being an election year it will be further delayed. Much like Solvency II in Europe, Dodd-Frank is so complicated a regulation in the US that by complying with one rule you are potentially going to be in violation of another.

Those international companies that are seeking to be in compliance with Dodd-Frank and US regulatory measures need to figure out how also to comply with Solvency II because most of the larger companies-- and the ones that fall within the remit of potentially being systemically significant-- are either European domestics or are doing business in Europe and need to comply with Solvency II issues. US regulators need to work with their European counterparts so there is "seamless regulation", ie, compliance with one is not a non-compliance in the other jurisdiction. The cost of compliance in both jurisdictions if they are not coordinated-- should this be the case-- would be astronomical and potentially contradictory.