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European Commission Proposes New Tools For Insurance Regulators

On Sept. 22, 2021, the European Commission (EC) proposed amending the EU's Solvency II directive and increasing harmonization of recovery and resolution regimes for insurers in the European Economic Area (EEA). In S&P Global Ratings' view, updating the EU's insurance regulatory framework as suggested would give national supervisory authorities an expanded toolbox and could support financial stability and consumer confidence. In particular, we regard the enhancements around supervisory tools to enforce liquidity risk management as central to the proposed amendments.

The proposal touches on various aspects of the Solvency II standard formula and includes the following new items:

  • Targeted harmonization of recovery and resolution regimes in the EU,
  • Stronger transparency in cross-border supervision, and
  • Updating re/insurers' regulatory capital requirements to reflect current thinking on climate change risks.

The proposal is still at an early stage; the technical standards are not due to be delivered until 18 months after the updated directive comes into force and then the changes have to be embedded into national insurance and insolvency laws. Based on our current understanding of the proposal, the proposed additional supervisory tools would not systemically heighten payment risk for insurers' hybrid bond issues. Thus, we do not expect them to weigh on our ratings on European re/insurers or on their hybrid bonds.

In our opinion, the EC's proposed changes to the standard formula are largely in line with proposals made by the European Insurance and Occupational Pensions Authority (EIOPA). Therefore, they could affect life insurers that use the standard formula (see "EIOPA's Proposals Increase The Economic Sensitivity Of Solvency II, At A Cost To Some Life Insurers," published on April 22, 2021).

Liquidity Risk Management Needs Better Enforcement

The EC's proposal suggests that in certain situations, supervisors should be able to enforce liquidity risk management, to the benefit of policyholders. Transitional benefits can be applied under Solvency II's original implementation; these will run out in 2032. Until this point, if an insurer does not have a solid business case to prove that it will be solvent without these arrangements by 2032, the directive's ladder of intervention can be used to disallow the transitional benefits. However, if the insurer has solvency capital requirement coverage of above 100%, national supervisory authorities and EIOPA can only make recommendations; they cannot force firms to take measures that would protect liquidity. As a result, in 2020, EIOPA was only able to request that insurers consider postponing dividends in light of the COVID-19 pandemic (see "Insurers' Dividend Pause Amid COVID-19 Concerns Likely Indicates Caution, Not Credit Risks," published on April 15, 2020).

Under the proposal, liquidity vulnerabilities might be shored up under exceptional circumstances. For example, if the European Systemic Risk Board declared a sectorwide shock, this would be classified as exceptional circumstances. Supervisors could then be empowered to stop the payment of dividends and coupons, and to halt policyholders from exercising their surrender rights. EIOPA's response to the proposal is likely to flesh out the details, but we consider that the proposal describes a severe crisis situation, and a tool which national supervisory authorities might use only cautiously, and as a last resort.

We consider liquidity risk management to be crucial for insurers. A prospective view on liquidity is embedded in our rating methodology (see "Insurers Rating Methodology," published on July 1, 2019). We stress test the prospective liquidity position of all insurers we rate, assuming heightened lapses, investments' market value depreciation, and unavailability of fresh liquidity. If we have concerns over an insurer's prospective liquidity for the next 12 months, including these stresses, we may cap our rating on the insurer at 'BB+', that is, below investment-grade.

In our analysis of historical defaults, we found that weaknesses in liquidity management has several times been the root cause of its failure (see "What May Cause Insurance Companies To Fail--And How This Influences Our Criteria," published on June 13, 2013). That said, 69% of the insurers we rate in EMEA have an exceptional liquidity position, with more than twice the liquidity required in our prospective stress scenarios. The remaining 31% have adequate coverage of above 1x under our prospective stress scenarios (see "EMEA Insurers Ratings List: Financial Strength Ratings And Scores," published on Oct. 11, 2021).

Harmonizing Ranking During Recovery And Resolution

There are material differences between the bail-out and bail-in structures in the resolution regimes that apply to insurers in some EU countries. The EC's proposal aims to align the ranking in case of resolution after an insurer reaches the point of nonviability. Specifically, the EC suggests that once shareholders' equity has been used, debt instruments should also carry losses before policyholders are affected.

Typically, insurers' Tier 2 hybrid instrument do not have any write-down or conversion features. If the EC proposal is incorporated in the national insurance and insolvency laws in the European Economic Area--the 27 EU countries plus Iceland, Liechtenstein, and Norway--this would change. Investors in Tier 2 instruments issued by an insurer might have to experience write-downs or conversion of the instrument during the resolution of that insurer. However, resolution bodies could use this tool, if enacted, only at the point of nonviability, and after depletion of shareholders' equity.

By contrast, although Tier 2 instruments issued by banks appear to display similar features, those who invest in them could face write-downs or conversion before the point of nonviability, if required to do so under state aid burden sharing measures.

We cannot exclude the possibility that the final implementation of this proposal in national laws could differ from our current understanding of the proposal. However, in our view, the proposal as such does not indicate a general increase in payment risk for the insurance sector across the EEA.

The EC proposal does not foresee any build-up of additional buffers or additional costs for insurers. The roll-out of recovery planning to the wider insurance sector is understood as part of good risk management. Although insurers might understand it as a regulatory burden, we see it as potentially beneficial for financial stability and consumer confidence.

Rethinking The Cost Of Climate Risk

In addition to the above measures, the EC has identified a potential need to reconsider capital charges for re/insurers in light of climate change. As demonstrated in the Intergovernmental Panel on Climate Change (IPCC) report published in August, experts increasingly agree that the physical effects of climate change are contributing to more frequent and extreme weather events. These will have a direct impact on the re/insurance industry.

Therefore, we anticipate that reinsurers that are exposed to natural catastrophe losses need to maintain reserving and capitalization in line with the longer-term trend (see "Global Reinsurers Grapple With Climate Change Risks," published on Sept. 23, 2021). Re/insurers have increased their efforts to incorporate climate change in their decision-making process, particularly in risk management, exposure management, and pricing. However, this is not yet a consistent and established practice across the industry. Many companies are finding it difficult to implement climate change considerations in a robust manner. Higher capital requirements, as mentioned by the EC in its proposal, might be a burden for reinsurers, but may also act as an incentive that forces re/insurers to change the way they consider climate risk in their underwriting and investing activities.

This report does not constitute a rating action.

Primary Credit Analyst:Volker Kudszus, Frankfurt + 49 693 399 9192;
Secondary Contacts:Taos D Fudji, Milan + 390272111276;
Simon Ashworth, London + 44 20 7176 7243;
Mark Button, London + 44 20 7176 7045;
Dennis P Sugrue, London + 44 20 7176 7056;

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