Solvency II review and the sustainability debate: old habits & new ideas

Carlos Montalvo Rebuelta looks at how sustainability could add purpose to the Insurance industry and why it's the stumbling block of the current Solvency II review

As the Solvency II review process progresses, both in terms of content as well as the positioning of the different stakeholders, some things are starting to become clearer, such as the fact that we will witness a new set of conditions for long-term equity eligibility, or a new methodology for extrapolation, inter alia.

Interestingly enough, it is in the area where there is more urgency, sustainability, where there has been less progress.

The current situation in a nutshell

Going back to the underlying process that must be followed to adopt (or amend) a Directive, the EU Commission has provided a proposal to the co-legislators; the Council has agreed on a compromise text; and the European Parliament has provided with amendments, that still have to be agreed as in some areas, certainly in the case of Sustainability, they are of very different, sometimes opposing, nature.

The Commission proposal on sustainability included the decision to integrate Climate change risks in the ORSA, rather than in Pillar 1, or the focus on channeling insurers´ investments into sustainable assets, requesting EIOPA to advise -by June 2023! - on "whether a dedicated prudential treatment of exposures related to assets or activities associated substantially with environmental or social objectives would be justified". It also provided EIOPA with an additional mandate; to look at, and report, whether the existing capital charges for (non-life) Natural Catastrophe risks remain adequate.

Furthermore, it waived low-risk profile undertakings -a new category of insurers introduced to enhance proportionality in the system- from the requirements set to insurers with material exposure to climate risk, to consider within ORSA the impact of long term-climate change risk scenarios in their business.

During the discussions at the Council, it was deemed that the Commission proposal was a good starting point, and only a few amendments were incorporated, namely that the review by EIOPA on a potential dedicated treatment for assets or activities should be risk based, as well as an extension of the requests to EIOPA to cover biodiversity, and a concrete requirement to EIOPA, EBA and ESMA regarding the need to develop supervisory stress-tests covering ESG, starting with climate related factors, and subsequently extending to Social and Governance ones.

Last, but not least, the European Parliament has shown a wide variety of views on this topic, ranging from the Rapporteur´s willingness to remove the entirety of the requests to EIOPA, to amendments from other groups heading into the opposite direction. At the time when this article has been written, there is not -yet- a single position from the EU Parliament.

From (objective) information to (personal) opinion

Moving from information to opinion, which may be one of the reasons why you are reading this article, its title talks about "old habits" and "new ideas", so let´s take a look -and if need be raise an orange flag- to what is currently on the table and what may be the direction of travel from here onwards.

Based on experience, let me start with a reminder to all stakeholders, about a pre-condition for a successful contribution from the insurance community to the sustainability challenge: regulatory certainty, which regulators tend to take for granted, or to underestimate. The sooner we are clear regarding the direction of journey, the quicker all parties will be able to "row" in the same direction... and the nature of this challenge is such that we cannot afford differently.

One of the most relevant decisions in this area, and one already taken, is the approach chosen by the EU Commission to integrate climate change risk within ORSA -through an assessment of the impact it has on existing risk modules- rather than within Pillar 1 as a new category. This is a pragmatic approach, yet one that will only have a positive effect where insurers run a realistic assessment of such impact, rather than one that is built defensively due to the fear that their supervisor will use that information to request an add-on (this is also a reminder to my former colleagues, the supervisors, that they should not use ORSA as a direct trigger for add-ons or on-sites, for they risk that insurers will end up writing their ORSAs with this in mind). EIOPA related work, in particular the ones providing so-called application guidance on climate risk scenarios in the ORSA, as well as that regarding expectations on how best to integrate climate change risks in stress-tests, should provide good guidance and be a useful tool for those that will embark in the design of new scenarios that capture the impact of climate change -also long-term- in the business.

Old habits

Yet, there are two particular approaches that I would like to underline, as part of what I have named "old habits", because if not properly addressed they may lead to sub-standard responses to the challenge : short-cuts and silos.

The type of short-cuts that are tempting to take in this debate include prioritizing considerations that ignore that any change must be risk based and data supported or forgetting that proportionality should always respect the principle of "same rules, different implementation".

The Commission has made public its strategy for financing the transition to a sustainable economy, and the expected role of the financial sector, including Insurance, in achieving the goals of the EU Green Deal, through a "sustainable finance framework that channels finance to investments that reduce exposure to climate and environmental risks".

The aforementioned could tease out a debate around the convenience of "green-supporting factors" as a way to speed-up the response of insurers on the asset side of their balance-sheets by investing –"more and better"- in sustainable assets. This is a perfect example of a short-cut that will not work, as we have seen in the past with the infrastructure debate, where politically driven goals led to regulatory incentives in the form of a more benign capital treatment for infrastructures, but did not succeed in making insurers to massively invest in such type of assets, mainly because insurers did what they should: run an assessment of the risks they would take, and the price they were getting for it, buying only those assets where risk-return matched.

Quoting Lord Byron, "the best of prophets for the future is the past", and the expectation gap between political expectations and reality should be a good indication of what may come in terms of effects of a green-supporting factor. At the same time, Byron gets it completely wrong -who doesn´t from time to time- when it comes to using past evidence in terms of severity and frequency of NatCat risk to forecast the future, as we know that what used to be a "one in one hundred years" will become a "one in ten" if we don't act.

Furthermore, moving the debate in this direction may avoid a much more relevant debate, namely How exposed is the Insurance sector to Transition risk; sometimes regulatory debates can influence risk management ones.

Let me add a word of caution for those that may be tempted by the concept of a "green supporting factor": in a few years' time, the debate will move from it to a "brown penalizing factor", because Society will push for more, and faster, change and, let´s be honest, there will be good reasons for further urgency. In such scenario, insurers will have lost the strongest rationale to avoid the "brown penalizing debate", namely that any sound risk-based framework, including capital charges, should always be evidence based.

There is another, less obvious short-cut I wanted to raise awareness of: as important as it is to bring proportionality to Solvency II, a what that we all support, the how matters; indeed, removing from the newly created category of "small and non-complex" (the name given by the Council to low-risk insurers) insurers the obligation to assess, as part of their ORSA, the impact of long-term climate change risk scenarios on their business may send the wrong message in an area, sustainability, where all parties must be part of the solution.

Isn´t there another way to incorporate a proportional approach to such requirement that does not imply fully removing it? Or is it that the business of "small and non-complex" insurers will not be affected by climate change risk? Let´s please work together on a sensible solution here, such us, just another idea, providing these entities with a phasing-in period that gives them time to adapt, but also enhances certainty around the requirements.

A few words around "silos", even if it may be unnecessary. I have spent more than 15 years working as a regulator, and when looking at micro prudential supervisory rules such as Solvency II, I would do so isolated to what was happening around conduct risk through the Insurance Distribution Directive (IDD). This is a mistake, as in real life everything is interlinked. Let´s make sure that sustainability risk debate captures and integrates both the insurer dimension, as well as that of the retail investor.

New ideas

The whole debate around integrating sustainability climate change risks in the framework seems to be focusing on capital charges and whether the approach -and the aforementioned capital charges- should be risk based or not. But it comes with a blind spot, in the sense that a risk-based system also embeds as a cornerstone of the model the acknowledgement that risk mitigation has to be rewarded. And if not addressed, such blind-spot will become a lost opportunity.

Whilst this is fully accepted e.g. when we think on reinsurance, we remain closed to extending the idea to other techniques such as spending money on risk pre-emption, building back better... as ways to reduce both frequency and intensity of future claims.

There are, however, good news or, at least, a window of opportunity: in addition to the mandate from the Commission to look at Nat Cat risk calibration and regulatory treatment of assets, EIOPA has decided, motu proprio, to also look at insurance liabilities, including a differentiating treatment for insurance contracts including climate-related adaptation measures. Isn´t this the right forum to initiate the debate on explicit recognition of pre-emption as a risk mitigation technique?

Allow me to better explain what I am saying with an example: it is well known and demonstrated that health insurers that have a program of medical checks significantly reduce their claims ratios, so that the costs incurred to run such examinations pay off via a significant reduction of claims, both in terms of number and cost. Putting numbers on top of words, in one of the territories where my employer, PwC, operates, the partnership is self-insuring health risk and, since they implemented a compulsory framework of extensive medical tests and reviews to all beneficiaries of the coverage, claims level went down by nearly 40%.

It may not always be as straightforward regarding other lines of business, but this should not be an obstacle that cannot be overcome; give insurers clear indication that, shall they provide evidence around the impact of pre-emption in their claims ratios this will be recognized as a risk mitigation technique and, sooner rather than later, such evidence will be there, to the full satisfaction of supervisors.

So, allow me to propose, from this article and to all relevant stakeholders, that they put into their agenda the topic of incentivizing within Solvency II those actions that lead to an effective risk reduction, and under which conditions investing in pre-emption as a way to reduce claims frequency and intensity can be considered as a risk mitigation technique eligible for reducing capital requirements, e.g. on the underwriting risk module. EIOPA ongoing work around insurance liabilities could be the perfect place to start debating this idea. But they cannot do this alone, and insurers will need to be part of it; not only this is in their own interest... it is in the interest of all of us!

A final note of Optimism: from Ugly duckling to swan?

Let me conclude with a reflection that has been underlying through this article, namely that around sustainability risk there is an opportunity dimension for the insurance sector that cannot be left aside: in addition to the role of insurers as investors, and the potential contribution to achieving the goals of the EU Green Plan by channeling investments towards sustainable assets, in their capacity as risk takers, they can proactively affect both frequency and, in particular, impact of natural disasters, helping reduce both through adequate investment in preemption. By so doing, they will add a clear purpose to insurance activity.

Allow me to share an interesting reflection during a lunch with one of the most prominent insurance minds in Europe, Michel Lies -chairman of the Zurich Group and former CEO of Swiss Re-, who talking about climate change, sustainability, and the role of insurance, told me that he no longer has to explain to his daughter what his job is about. From there to making insurance an attractive sector for younger generations, who in the past never felt attracted to work in insurance as a first option, but today search for a purpose in their work and life, there is only a little step; one that we should already be taking. Having spent about 25 years of my life working in Insurance, I can only be passionate about it, and I hope that many others find the same element of reward that I do and join us as a priority professional destination.

Carlos Montalvo Rebuelta is a partner at PwC. Previously he was executive director at EIOPA.