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Grounded in paradox: EU Commission insurance sector prudential rules review proposals

Insurance & Pensions

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Commission recognises need to address too-big-to-fail in the insurance sector but fails to tackle major threat to financial stability posed by climate change.

The following statement by Finance Watch covers two European Commission legislative proposals released today: one on the review of Solvency II as well as one on the Insurance Resolution and Recovery Directive.

BRUSSELS, 22 September 2021 – The  proposals of the European Commission for a review of the insurance sector prudential regulation are grounded in a paradox. On the one hand, they recognise the systemic nature of the sector by introducing, in a most welcome move, a directive  introducing a harmonised recovery and resolution framework for  insurance companies. But, at the same time, they fail to address the biggest of all threats to financial stability of the insurance sector, climate change, despite the possibility to do so by simply adjusting capital requirements.

Systemic nature of insurance industry recognised 

The draft insurance recovery and resolution directive (IRRD) aims to avoid any future bailouts of insurers. It sets out key requirements on resolution authorities (article 3), resolution planning (articles 4-12) and resolvability (articles 13-16) to preempt insurer failures. The directive proposes tools to resolve failing insurers and safeguards for policyholders when they are used (article 22).

Equivalent rules for the banking sector have shown us that implementation and enforcement of recovery and resolution frameworks in EU Member States is essential but extremely difficult, if not impossible in many cases. This ultimately sets the limit of recovery and resolution regimes. Experience has taught us that the road to resolving large financial institutions is paved with obstacles.

A risk-based framework for unexpected losses, but not for the climate crisis we expect

Financial risks related to climate change are a major threat to the stability of the insurance sector and the financial system as a whole. The insurance industry provides staggering amounts of investment and insurance coverage to fossil fuels. Fossil fuel assets, however, are likely to be partially or fully stranded in the transition to carbon neutrality. In addition, financing of fossil fuels is accelerating physical risks stemming from climate change-related natural catastrophes, leading to increasing unexpected losses for insurers.

Addressing this risk is very simple. It only requires adjusting the capital requirements rules for fossil fuel financing in Solvency II according to the high risk profile of these assets. By having capital requirements in place that are not consistent with the riskiness of fossil fuels, Solvency II is currently not in coherence with itself as a risk-based tool.

We very much welcome that today’s proposals include the much needed introduction of an EU harmonised recovery and resolution framework. As highlighted by many experts and policymakers such as EIOPA and the ESRB for a while now, the insurance sector is vulnerable and systemic. However, to protect taxpayers from having to bail out too-big-to-fail insurance companies, we not only need a recovery and resolution framework but also need to ensure that these financial institutions are properly capitalised. This can only be achieved by incorporating the biggest risk to financial stability – the financial risks related to climate change – in the capital requirements rules of Solvency II.

Article 191 of the Treaty on the Functioning of the European Union (TFEU) sets out the Union’s policy on the precautionary principle and refers explicitly to the duty of combatting climate change, requiring EU policy-makers to take preventive action in the case of risk

The measures put forward in today’s proposals do not meet this obligation. Integrating “scenario analyses” in insurers’ internal risk management system won’t bring about any prudential actions given the radical uncertainty of climate events which render quantitative modelling unable to lead to meaningful conclusions and well-informed change.

The proposal on prudential rules for natural catastrophes, as in the case of scenario analyses, relies on climate risk modelling and measurement as well, which, as stated above, is faced with challenges and uncertainties. Even climate scientists confirm that the recent climate-related events could not have been predicted by climate models.

The mandate given to EIOPA in today’s proposals to explore by 2023 whether any capital requirements measures should be taken must be seen within the perspective of the TFEU legal obligation to act immediately.

No harmonised insurance guarantee schemes

We are disappointed with the Commission’s decision not to propose the introduction of harmonised insurance guarantee scheme rules to protect / compensate policyholders in case of an insurance company failure. Every Member State must have an insurance guarantee scheme to ensure adequate levels of protection for policyholders across Europe. This vital safety net is needed to ensure that European citizens and policyholders do not have to bear the consequences of insurance company failures.

Need for more ambition regarding macro-prudential tools

Macro-prudential tools are needed in Solvency II to help ensure financial stability as our July consultation response pointed out. The Commission rightly includes many of them, including a harmonised recovery and resolution scheme for insurers.

We back the Prudent Person Principle, whereby insurers will be required to factor plausible macroeconomic and financial markets’ developments into their investment strategy and assess the extent to which their investments may increase systemic risk. Updating the Solvency in Financial Condition Reports (SFCR) will bring a more accessible reporting format to consumer and expert stakeholders alike.

On the EU level, we back the proposal for EIOPA to play a role in cross-border disputes between supervisors for cross-border insurers and a rule that supervisory authorities would be required to cooperate more.

A first tentative step has been taken to address liquidity risk, but falls short of the recommendations for liquidity buffers of the ESRB. However, there has been a recognition of the need to formalise supervisor intervention to suspend dividend payments and limit variable remuneration in exceptional cases, learning from the experience of the COVID crisis.

Thierry Philipponnat, Finance Watch Head of Research and Advocacy said: “The Commission proposal to introduce a European insurance recovery and resolution framework is an admission that the insurance sector is systemic and vulnerable. This proposal is essential and should be supported. But the lack of action to address sustainability risk is puzzling in this context, as it is one of the largest risks the sector faces today.

Benoît Lallemand, Finance Watch Secretary General said: “The Commission proposes little concrete action to address the link between financial stability and climate change. This is not coherent with the aim of Solvency II as a risk-based framework and implicitly leaves the taxpayer to pick any future bill from financial instability caused by climate change.

For media enquiries, contact James Pieper, Senior Editorial and Press Officer, Finance Watch, on +32 496 51 72 70 or at james.pieper@finance-watch.org

Notes to editor:

 

 

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