Solvency II – Persist in identifying your limitations and you will fulfil them

If we look back to 2008, the year from which most of the current batch of regulations ensued, it is important to look at the lessons learned by the survivors of the crisis. The aftermath showed that it was difficult to track exposure to any given entity, be that a security, a sector, a currency or a country. Also, the impact on all the entities that had crossover with failing firms caused contagion across the market.

So, the message was, understand your counterparty risk, market risk and credit risk. Focus on the critical parts of risk management. Firms need an accurate, consolidated view of risk across their business. Understand that regulations are put in place for reasons ranging from investor protection, anti-money laundering, tax avoidance and protection of markets against systemic risk. And the most basic of all, know your investments.

The new world order requires transparency. The ‘black box’ products of the past are no longer fit for purpose, and certainly not for risk management if a best practice approach is to be applied.

So, what has happened in the journey to transparency with Solvency II?

The initial principle was to provide  granular transparency through to position-level data, the look-through principle. This is consistent with lessons learned from the crisis. Insurers who were leading the charge in putting their processes in place went out to the market to source data from their asset managers. The response was not exactly what they expected, ultimately making them realise the limitations of getting the data required to gain full look-through.

There are many reasons for this, such as: the critical nature of the intellectual property being asked for, the timing of the data required and even the complexity of getting this data out of multiple systems.

So, faced with this inability to get transparent information, insurers went back to the regulator and the options of default type 2 equity and the mandate approaches came into play.

And hence we see the folly of the industry’s limitations being fulfilled.

At present, there are mixed messages permeating the market. Some say that they have decided to take one or other approach, and others are looking for the path of least resistance (mandate). Many ignore the fact that the regulation does not state ‘pick one from three’.  It states that the principle of look-through should be applied and that SCR should be calculated on each of the underlying assets of collective investment vehicles.

Where this approach cannot be applied, equity ‘type 2’ charge shall be applied.  And where full look-through cannot be applied and the fund strictly follows a mandate, reference should be made to the mandate of the investment scheme.  This does not mean that the option is open to choose to not use look-through when available.

The purpose of the other options is to enable calculations to be made, with the penalty of a higher capital requirement. This allows insurers to decide whether that investment is worth retaining taking into account both the penalty and the fact that it diminishes the risk management process that are being applied.

So how will the regulator and auditors respond when one insurer provides look-through on a fund and another insurer points out limitations in being able to do so? It will be interesting to see how the insurer who can’t provide look-through justifies their position…