Solvency ii News January 2013

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SolvencyII and legal challenges…
EIOPA wantsnational supervisorstoensure that insurancefirms havein
placeSolvencyII basedriskmanagement, corporategovernance and
OwnRisk and SolvencyAssessment (ORSA), well beforethe SolvencyII
deadline. The interestinglegal challenge:DoesEIOPAhavetheauthority
and thelegal powerto implement earlya regime that hasyet tocome into
effect, and is not final yet?
Theseweekswehave the debateabout how muchcapital insurers
should hold to meet life insurancepolicyguarantees. The European
Parliament plenaryvote on Omnibus2 waspushedback to
accommodatethis study and is currentlyscheduledfor June 10.
www.solvency-ii-association.com

Sebastian von Dahlen and Goetz von Peter
Natural catastrophesand global
reinsurance – exploring the linkages
Natural disasters resulting in significant losses
have become more frequent in recent
decades, with 2011 being the costliest year in
history.
This feature exploreshow riskis transferred
within and beyond the global insurancesector
and assessesthe financial linkagesthat arisein
the process.
In particular, retrocessionand securitisation allowfor risk-sharingwith
other financial institutionsand the broader financial market.
While the fact that most risk is retained within the global insurance
market makestheselinkagesappear small, theywarrant attention due to
their potential ramificationsand thedependencies they introduce.
Theviewsexpressedin this article are thoseof the authorsand do not
necessarilyreflect thoseof the BIS, the IAIS or anyaffiliatedinstitution.
We wouldlike to thank Anamaria Illesfor excellent research
assistance,and Claudio Borio, Stephen Cecchetti, Emma
Claggett, Daniel Hofmann, Anastasia Kartasheva,Andrew Stolfi and
ChristianUpper for helpful comments
Thephysical destruction caused by severe natural catastrophestriggersa
seriesof adverseeffects.
Damagedproduction facilities,shatteredtransportation infrastructure
andbusinessinterruptionproduceboth direct lossesand indirect
macroeconomiccostsin the form of foregoneoutput (von Peter et al(2012)).

Beyond theseeconomiccostsare enormoushuman sufferingand a host
of longerterm socioeconomicconsequences, documented bythe World
Bank and United Nations(2010).
By examining catastrophe-related losses over the past three decades, this
special feature explores the linkagesthat arise in the transfer of risk from
policyholders all thewaytothe ultimatebearer of risk.
It describesthe contracts and premiumsexchangedfor protection, and
thewayreinsurersdiversify and retain riskson their balancesheets.
In sodoing, the feature traceshow lossescascadethrough thesystem
whenlargenatural disastersoccur.
Lossesfrom insuredpropertyand infrastructure first affect primary
insurers,whoin turn rely on reinsurersto absorb peak risks– low-
probability, high-impact events.
Reinsurers,in turn, usetheir balancesheetsand, to a lesser
extent, retrocessionand securitization arrangements,tomanage
peak risksacrosstime and space.
[Retrocession takesplacewhen a reinsurerbuysinsuranceprotection
from another entity.
Securitisation refers tothetransfer of insurance-relatedrisks(liabilities)
tofinancial markets.]
This global risk transfercreateslinkageswithin the insuranceindustry
andbetweeninsurersand financial markets.
While securitisation tofinancial marketsremainsrelatively
small, linkagesbetweenfinancial institutionsproduced through
retrocessionhavenot been fullyassessedasdetaileddata are lacking.
Further linkagescan arise whenreinsurersgobeyond their traditional
insurancebusinesstoengagein financial market activitiessuch as

investment bankingor CDSwriting;the implicationsof thoseactivities
are beyond the scope of thisfeature.
Comprehensive informationis needed tomonitor the entire risk transfer
cascadeand assessitswiderrepercussionsin financial markets.
Physical damage and financial losses
Natural catastrophesresulting in significant financial losseshave
become more frequent over the past threedecades(Kunreuther and
Michel-Kerjan(2009), Cumminsand Mahul (2009)).
Theyear 2011witnessedthe greatest natural catastrophe-relatedlossesin
history, reaching $386billion (Graph 1, top panel).
Thetrend in lossdevelopmentscan be attributed in large measureto
weather-relatedevents(Graph 1, bottom right-hand panel).
And losseshave been compounded by risingwealthand increased
populationconcentration in exposed areassuch ascoastal regionsand
earthquake-pronecities.
Thesefactorstranslateintogreater insured losseswhereinsurance
penetration is high.
At $110billion, insured lossesin 2011came closeto the2005record of
$116billion (in constant 2011dollars).
Thereinsurancesector absorbed more than half of insuredcatastrophe
lossesin 2011.
This considerableburden on reinsurersreflectedthe materialisationof
variouspeak risks, notablyin Japan, New Zealand, Thailandand the
UnitedStates.
Thelevel of insuredlossesalsodependson catastrophes‘geography and

physical type.
Thebottom panelsof Graph 1show that lossesdue toearthquakes
(geophysical events) havebeen lessinsuredon averagethan thosefrom
storms(meteorological events).
The highest economic losses caused by geophysical events occurred in
2011 in the wake of the Great East Japan earthquake and tsunami ($210
billion), for which private insurance coverage was relatively low at 17%
(lefthandpanel).
Droughtscan be even more difficult to quantify and insure.
By contrast, the right-hand panel of Graph 1showsthat meteorological
eventsproduced record lossesin 2005, whenHurricanesKatrina, Rita
andWilma devastateda region of the USGulf Coasthaving50% or more
in insurancecoverage.
Thevolume of insured lossesdifferssubstantiallyacross
continents,dependingon theavailability of and demand for
insurance.
While overall a slight upward trend can be discerned over the past 10
years, the widedispersion in insurancedensity indicatesthat the stage of
a region‘seconomicdevelopment playsan important role(Graph 2, left-
hand panel).
Residentsof NorthAmerica, Oceania and Europe spend significant
amountson non-life (propertyand casualty) insurance, whereasmany
populouscountriesin LatinAmerica, Asia andAfrica host
underdeveloped insurancemarkets.
Poor countries typically lack thefinancial and technical capacityto
provideaffordableinsurancecoverage.
For example, lessthan 1% of the staggeringeconomiclossesdue to
Haiti‘s2010earthquakewereinsured.

Thepattern of insuredlossesthusonlypartly reflectsthe geography of
natural catastrophes.
Sources: Centre for Research on the Epidemiology of Disasters EM-DAT database; MunichRe NatCatSERVICE; authors’ calculations.

NorthAmerica accountsfor thelargest insured lossesassociatedwith
natural disasters(Graph 2, right-hand panel).
In 23of the 32years since1980, more than half of global insured losses
originatedin the region, though part of this volume wasredistributed
through global reinsurancecompanies.
Asia, Oceania and, toa lesser extent, Latin America sawincreasesin
catastrophe-relatedlosseson theback of risinginsurancedensityover
thepast 10years.
Correspondingly, thesethree regionsaccount for a rising shareof
insuredlosses.
Risk transfer
Natural catastrophe-relatedlossesare largeand unpredictable.

Theinsured lossesshownin Graphs1and 2reflect recent experience.
This section describesthe sequenceof paymentsbased on contractual
obligationsthat is triggeredwhenan insured event materialises.
One can think of theinsurance market asorganisingrisk transferin a
hierarchical way.
Lossescascadedown from insuredpolicyholders to the ultimate
bearers of risk (Graph 3).
When catastrophestrikes, the extent of physical damage determines
total economiclosses,a largeshare of whichis typically uninsured.
Theinsured losses,however,must be shoulderedby the global insurance
market (Graph 3, light grey area).
Thepublic sector, whenit insuresinfrastructure, often doessodirectly
with reinsurersthrough public-privatepartnerships,although more data
wouldbe necessarytopin down the exact scope worldwide.
Themajorityof the lossesrelate to privateentitiescontractingwith
primaryinsurers,the firms that locallyinsure policyholders against risks.
Claimsfor reimbursement thusfirst affect primary insurers.
But theyabsorbonlysome of the losses,having ceded (transferred) a
shareof their exposure toreinsurancecompanies.
Reinsurersusuallybear 55–65% of insuredlosseswhena largenatural
disasteroccurs.
Theydiversify concentrated risksamong themselvesand passa fraction
of losseson to thebroader financial market, whileultimatelyretaining
most catastrophe-relatedrisk (seesection below).

Before disaster strikes,however, there isa correspondingpremium flow
in exchangefor protection.
Basedon worldwideaggregate premium paymentsin 2011, policyholders
and insured entities, both privateand public sector, spent $4,596billion to
receiveinsuranceprotection.
Some43% of this global premium volume ($1,969billion) relatestonon-
life insuranceand theremainder tolife insuranceproducts(IAIS(2012)).
Primary insurers, in turn, paid closeto$215billiontobuy coveragefrom
reinsurers.
Thelion‘sshare, nearly$165billion, camefrom primary insurersactive
in thenon-life business.
About onethird of this amount, $65billion, wasgeared towards
protection against peak risks, with $18 billion for specific natural
catastrophecontracts.
By wayof comparison, life insurance companiesspent 2% of their
premium income, $40billion, on reinsuranceprotection.
This comparatively lowdegreeof reinsuranceprotection isdue to thefact
that resultsare typically lessvolatile in life insurancethan in non-life
insurance.
Followinganyrisk transfer, insurersremain fullyliablevis-à-visthe
policyholder based on the initial contractual obligations,regardless of
whetheror not the next instancepaysup on the ceded risk.

Reinsurancecompanies, in turn, buy protection against peak risksfrom
other reinsurersand financial institutions.

In thisprocessof retrocession, reinsurersspent $25billion in 2011to
mitigatetheir own downsiderisk.
Thebulk of thisamount representsretrocededriskstransferredto other
reinsurancecompanies ($20billion in premiums), whilea relatively small
shareisceded to other market participantssuch ashedgefundsand
banks($4 billion) and financial markets($1billion).
An important aspect of thisstructure isthe prefunding of insured risks.
Premiumsare paid ex antefor protectionagainst an event that may or
may not materialise over thecourse of the contract.
Thesepaymentsbypolicyholders and insurersgeneratea steady
premium flowto insurersand reinsurers,respectively.
Onlyif and when anevent withthe specified characteristicsoccursare
theclaims paymentsshown in Graph 3 triggered.
At all other times,premium flowsare accumulatedin the form of assets
held against technical reserves(seenext section).
Reinsurancecontractscome in twobasic forms whichdiffer in the way
primaryinsurersand reinsurersdeterminepremiumsand losses.
Proportional reinsurancecontractsshare premiumsand lossesin a
predefined ratio.
Sincethe 1970s,non proportional contractshave increasinglybeen used
asa substitute.
Instead of sharinglossesand premiumsin fixed proportions,both
partiesagree on theinsured risksand calculate a specific premium on
that basis.

Thetypical non-proportional contract specifiestheamount beyond
whichthe reinsurer assumeslosses,up toan agreed upon ceiling (first
limit).
Depending on the underlying exposure, a primary insurer may decideto
buy additional layersof reinsurancecover, for examplewithother
reinsurers,on top of the first limit.
―Excessof loss‖ agreementsare themost common form of non-
proportional reinsurancecover.
For natural catastrophes,thesecontractsare knownasCatXL
(catastropheexcessof loss) and cover thelossexceedingtheprimary
insurer‘sretention for a singleevent.
Amajor earthquake,for example, is likelyto affect the entire portfolio of
a primary insurer, leadingtothousandsof claims in different linesof
business,such asmotor, businessinterruption and privateproperty
insurance.
As a result, primary insurersoftenpurchaseCatXL coveragetoprotect
themselvesagainst peak risks.
Peak risksand the reinsurance market
Areinsurer‘sbalancesheet reflectsitscurrent and past acceptanceof
risksthrough itsunderwritingactivity.
Dealingwith exposureto peak risks, whichrelateto natural
catastrophes,is thecore businessof thereinsuranceindustry.
Natural catastrophesare rootedin idiosyncratic physical eventssuchas
earthquakes.
When underwritingnatural catastropherisks, reinsurerscan rely toa
largeextent on the fact that physical eventsdonot correlate
endogenouslyin thewayfinancial risk does.

To achievegeographical diversification, reinsurersoffer peak risk
protectionnot just for one country but ideallyon a worldwidebasis.
Another form of diversification takesplaceover time.
Premiumsare accumulatedover years, and claimspaymentsare usually
paid out over the course of monthsor sometimesyears.
Graph 4 (left-handpanel) showstheaveragepayout profile for CatXL
contracts.
Statisticson reinsurancepaymentsshow that claimsare typically settled
over anextendedperiod.
On average, 63% of theultimateobligationsare paid withina year and
82%within twoyears, and it takesmore than five years after a natural
disasterstrikesfor thecumulativepayout to reach 100%.

Thepremium inflowsnot immediately usedfor paying out claims are
investedin variousassetsheld for meeting expectedfuture claims.
In thisway, reinsurersbuild specific reserves calledtechnical provisions.
Theseconstitutethelargest block of reinsurers‘on-balancesheet
liabilities(Graph 4, right-hand panel).
Insuredlossesaremet by running downassetsin linewiththese
technicalreserves.
Lossesin any one year typically lead to lossratios(incurred lossesasa
shareof earned premium) of between70 and 90%.
Todetermine whethera reinsurer can withstandsevereand
unprecedented(yet plausible) reinsuredevents,regulatorslook for
sufficient technical provisionsand capital on the reinsurer‘sbalance
sheet.
Theoccurrenceof a major natural catastrophedentsreinsurers‘
underwritingprofitability, asreflectedin thecombinedratio.
This indicatorsetscostsagainst premium income.
Acombined ratioabove 100% is not sustainablefor an extendedperiod.
By contrast, temporary spikesin the combined ratioare indicativeof one
off extreme eventswhichcan be absorbed by an intertemporal transfer of
risk.
Thecombined ratiospiked in theyearsfeaturing themost costlynatural
catastrophestodate(Graph 5, blue line): 2005, the year of major
hurricanesin the US, and 2011, followingearthquakesand floodingin
Asia and Oceania.
Both occasionsalsoreducedthe stock of assetsreserved for meeting
claims.

Yet thesetemporaryspikesin the combined ratio did not cut through to
shareholder equitytoany significant extent.
Catastrophesaffect equityonly if lossesexceedthecatastrophereserve.
Recent market developmentscausedshareholder equityto decrease
more than insurers‘coreunderwritingbusinessever has.
During the global financial crisisof 2008–09,shareholder equity(book
value) declinedby 15% (Graph 5, red line), and insurancecompanies‘
sharepricesdropped by 59% (yellow line), more than after anynatural
catastropheto date.
In contrast, shareholder equityremainedresilient in 2005and 2011, when
reinsurersweatheredrecord high catastrophelosses.
In dealingwiththe consequencesof peak catastropherisks,the industry
hasgravitatedtowardsa distinctivemarket structure.
One important element isthe size of reinsurancecompanies.
Assessing and pricinga largenumber of different potential physical
eventsinvolvesrisk management capabilitiesand transaction costson a
largescale.
Balancesheet size is thereforean important tool for a reinsurertoattain
meaningful physical diversificationon a global scale.
Partly as a result, the 10 largest reinsurance companies account for more
than 40% of the global non-life reinsurance market (Graph 6, right-hand
panel).

In spite of thereinsurancemarket‘ssizeand concentration, failures of
reinsurancecompanies have remained limitedin scope.
Thelargest failurestodate, comprising twobankruptciesin 2003, ledto
an essentiallyinconsequential reduction in availablereinsurance
capacityof 0.4% (Graph 6, left-handpanel).
That said, any failureof a reinsurer leadsto a lossof reinsurance
recoverablesbyprimary insurers,and could causebroader market
tensionsin the event of a disorderlyliquidationof largeportfolios.
In thisrespect, the degreeof connectednesswithin the global insurance
market plays an important role.
Basedon their businessmodel, reinsurersenter intocontractswitha
largenumber of primary insurancecompanies,giving rise tonumerous
verticallinks(Graph 3).
In addition, risk transferbetweenreinsurersleadstohorizontal linkages.
We estimatethat 12% of natural catastrophe-relatedrisk accepted by
reinsurersistransferred withinthereinsurance industry, whichimplies
that the industry asa wholeretainsmost of therisksit contracts.
In 2011, reinsurerspaid 3% of earnedpremiumstocede catastropherisk
toentitiesoutsidethe insurancesector.
Judgingby premium volume, the global insurancemarket transfersa
similarlysmall share of accepted risk toother financial institutionsand
thewider financialmarkets.
Linkageswith financial markets
Arrangementsdesignedtotransfer riskout of the insurancesectorcreate
linkageswithother financial market participants.
Retrocessiontoother financial institutionsusescontractual
arrangementssimilar tothosebetweenreinsurers,and commitsbanks

and other financial institutionsto pay out if the retrocededrisk
materialises.
Securitisation, on theother hand, involvesthe issuanceof insurance
liabilitiestothe widerfinancial market.
Thecounterpartiesare typically other financial institutions,such as
hedgefunds, banks, pension fundsand mutual funds.
Among insurance-linkedsecurities, catastrophebondsare themain
instrument for transferringreinsureddisaster risksto financial markets.
Theexogenousnature of theunderlying risks supportsthe view that
catastrophebondsprovide effectivediversificationunrelated tofinancial
market risk.
For thesereasons,industry expertshad high expectationsfor the
expansion of the catastrophebond market (eg Jaffeeand Russell
(1997), Froot (2001)).
Theissuanceof catastrophebondsinvolvesfinancial transactionswitha
number of parties(Graph 7).
At the centre is a special purposevehicle (SPV) whichfundsitself by
issuingnotestofinancial market participants.
TheSPV investsthe proceedsin securities,mostly government bonds
whichareheld in a collateraltrust.
Thesponsoringreinsurer receivestheseassetsin casea natural disaster
materializesasspecified in thecontract.
Verifiablephysical events, such asstorm intensitymeasuredon the
Beaufort scale, serve asparametrictriggersfor catastrophebonds.
Investorsrecoup thefull principal only if no catastropheoccurs.

In contrast toother bonds, thepossibilityof total lossispart of the
arrangement from inception, and iscompensatedex anteby a higher
coupon.

Despiteexperts‘high expectations,the catastrophebond market has
remainedrelativelysmall.
Bond issuancehasnever exceeded$7 billion per year, limitingthe
outstandingcapital at risk to$14billion(Graph 8).
Very few catastrophebondshave beentriggeredto date.
The2005Gulf Coast hurricanesactivatedpayoutsfrom only one of nine
catastrophebondsoutstandingat the time (IAIS(2009)).
Likewise, the2011Japan earthquakeand tsunami triggeredone known
catastrophebond, resultingin a payout of lessthan $300million.
Payoutsto reinsurersfrom these bondsare small whencompared tothe
sum of insured losses($116billion in 2005and $110billion in 2011).
Theglobal financial crisishasalsodealt a blow to thismarket.

Theyear 2008saw a rapid declinein catastrophebond
issuance,reflectinggeneralisedfunding pressureand investorconcern
over thevulnerabilityof insuranceentities.
Thecrisisalsodemonstrated that securitisationstructuresintroduce
additional risk through linkagesbetweenfinancial entities.
Acasein point wasthe Lehman Brothersbankruptcyin September 2008.
Four catastrophebondswereimpaired – not duetonatural
catastrophes,but becausetheyincluded a total return swapwithLehman
Brothersacting asa counterparty.
FollowingLehman‘sfailure, thesesecuritizationarrangementswereno
longer fullyfunded, and their market valueplunged.
Investorsthuslearnedthat catastrophebondsare not immune to
―unnatural‖ disasterssuch asmajor institutional failures.
Afurther set of financial linkagesariseswith other financial institutions
through cross-holdingsof debt and equity.
Insurancecompanieshold largepositionsin fixedincome
instruments,includingbank bonds.
At the same time, other financial entitiesownbondsand stocks in
insurancecompanies.
For instance, the twolargest reinsurancecompaniesstatedin their latest
(2011) annual reportsthat Warren Buffett and his companies (Berkshire
HathawayInc, OBH LLC, National IndemnityCompany) ownvoting
rightsin excessof thedisclosurethreshold (10%in one caseand 3.10% in
another).
Additional shareholderswithdirect linkagestothe financial sector have
been disclosedby a number of reinsurancecompanies.

Theramificationsof such linkagesin thispart of themarket aredifficult
toassess.
Conclusion
The upward trend in overall economic losses in recent decades
highlights the global economy‘s increasing exposure to natural
catastrophes.
This development hasled tounprecedentedlossesfor theglobal
insurancemarket, where theycascadefrom the policyholdersvia primary
insurersto reinsurancecompanies.
Reinsurerscopewith these peak risksthrough
diversification, prefunding and risk-sharingwithother
financial institutions.
This global risk transfercreateslinkageswithin the insuranceindustry
andbetweeninsurersand financial markets.
While securitisation tofinancial marketsremainsrelatively
small, linkagesbetweenfinancial institutionsarisingfrom
retrocessionhavenot been fullyassessed.
It is important for regulatorstohave accesstothe data neededfor
monitoring the relevant linkagesin theentire risk transfer cascade,asno
comprehensiveinternational statistics exist in this area.

EIOPA – Risk Dashboard
Systemic risks and vulnerabilities
On thebasis of observed market conditions, data gathered from
undertakings,and expert judgment, EIOPAassessesthemain systemic
risksand vulnerabilitiesfacedby the European insuranceindustry over
thecoming quarterstobe:
• Macrorisks:
Recessionarypressure in a number of economiesin the EU exemplify
the macro-economicrisks whichare still at an elevatedlevel.
Although several important stepshave been taken recentlyboth at the
European and national level, uncertaintyremainswithregard to any
remainingimplementation risks.

In addition, thecombination of austeritymeasures,rising
unemployment and a prolonged period of subduedgrowthcould have
negativeeffectson insurancedemand.
• Credit and market risk:
Thetrend of decreasingCDSspreadshascontinued.
However, thisdevelopment certainlyisalsodriven by excess
liquidity, thedifficult global financial investment environment and
investors‘riskappetitestriving for an appropriatebalanceof yield versus
risk.
Recent changesin asset allocation of European insurersrather hint at a
reducedrisk appetiteconcerning credit investments.
Theytend to shift investmentstowardslessriskier
counterparties,reducingtheir European sovereign and banking
exposure.
This indicatesa continuation of a negativeoutlook/ perceptionon that
credit category.
Market risksare still dominated bythe low yield environment with10year
swapratesin Western Europe having again reachednew lowsin thepast
months.
• Stabilisationin life insurance business:
Thedecliningtrend in life grosswrittenpremiumshasbeen
reversed, however growthratesare still rather subdued.
Lapseratesin the samplehave improved from their peak in Q4 2011and
remainedstablesincelast quarter.

Use of expert judgment
Use of expert judgment after the mechanical aggregation:
• Macrorisk:
Slightlyupwardsdue to high heterogeneityin growthfiguresacrossEU
countriesand general uncertaintyabout themedium term growth
potential and itsimplicationsfor the demand of insuranceproducts.
In addition, implementationrisksaround thevariouscrisismanagement
toolsused in the sovereigndebt crisisare non negligible.
• Credit risk:
Slightlyupwardsastheobserved decreaseof themechanistic score is
consideredtoolargegiventhe uncertainmacro outlook, potentially
distortedbond pricesasa result of excessliquiditywhile at the same

timeinvestorshave limitedalternativestosubstantiallyreducetheir
credit risk exposure.
• Market risk:
Slightlyupwardsdue to the severe consequencesa prolonged low yield
environment could haveon the profitability and solvencyof the
insurancesector.
Improvementsin other indicators,e.g. equityrisk, arenot considered to
make up theeffectsof recentlyobserved new historic lowsin 10_year
swaprates, giventhe on averagesmall equityinvestmentsof insurers.
• Liquidity&funding:
Slightlydownwardsasthe increaseof the mechanistic score is solely
driven by low issuancevolume of cat bondsin Q3 whichisseasonally
driven and isalready pickingup substantiallyin October and November.
Other indicatorsremained stable.
• Insurancerisk:
Slightlyupwardsdue to reducedbuffersof reinsurersfor catastrophe
lossesafter HurricaneSandy and potential price hikes in upcoming
renewals,whicharenot reflected in Q3 figuresyet.
In addition, insurers‘businessmodel might be impacted in a lowyield
environment whenlowerinvestment returnscannot counter balance
potential underwritinglosses.

Sovereign risk – a world without risk-
free assets
Panel commentsbyMr Patrick
Honohan, Governor of theCentral Bank of
Ireland, at the BISConferenceon
―Sovereign risk – a worldwithout risk-free
assets‖,Basel,8January2013.
What‘snew about sovereignrisk sincethe
crisisbegan?
Conceptually, not somuch, I wouldsuggest – and nothingthat cannot
befullyexplainedwithinstandard modelsof finance.
But in practice, and in particular in theeuro area, twolinkedelements
that werealwayspotentiallypresent or implicit have leapt into
prominencein a wayand toan extent that wasnot foreseen.
Thefirst isthat marketshave begun to price default risk in a sovereign‘s
home-currency;
Thesecond is the contamination of the functioningand economic
effectivenessof banks by theweakcredit rating of their sovereigns(as
well asvice versa).
I have to admit to the possibility that my remarks may be subject to
some professional deformation here, in that my perspective on these
matters is likely coloured by my pre-occupation with the situation in
Ireland.
Ireland hascertainlydisplayed thesetwoelementsin a dramaticway, but
theyare evidentlypresent in half a dozen other euroareacountriesalso
andtoan extent whichhashad implicationsfor the functioningof the
Eurosystem asa whole, and thereforeon the global financial system.

Let me take thesetwopointsin turn.
First the pricing-inof sovereigndefault risk in ―home currency‖.
Why did the default premium suddenly emerge?
Evidently, even though everyone understood the rules, nosuch pricing-
in occurred for the first decade of theEurosystem (Figure 1).
Riskappetitewashigh for much of that period, but the market‘s
perception of sovereign risk must alsohaveremained low.
(Perhaps,despiteTreatyprohibitions,market participantsassumedthat
anysovereign that got intotroublewouldbe bailed-out).
Indeed, sovereign spreadsin the euro area werealmost totallyinsensitive
tocredit ratingsbefore the crisis(Figure 2).
One often-heard interpretation of what happened during that decade is
that the complacent market environment relaxed the budget constraint
on euro-areasovereignsand ledthem toborrow recklessly.
Actuallythis story doesn‘t fit the factsvery well.
After all, although sovereign debt ratiosin most of the Eurosystem did
not fall asmuch astheycould and should have on thegood years, at
least theydid not increasedramaticallybeforethecrisis(Figure 4).
(Private debt ratios, and in particularthesize of the bank and near-bank
systems did increase, but that is a somewhat different story, towhichI
will turn shortly).
It‘s possiblealternativelythat there wasa multipleequilibrium here, with
the―good‖ or lowinterest equilibrium (with a self-fulfillingdegreeof
confidencein the creditworthinessof all thesovereigns) beingselectedby
themarket at thestart of theeuro, and eventsduring thefinancial

crisis– not least thoseassociated withGreece– havingtrippedthe
system intothe ―bad‖ or high interestequilibrium with default risk
premia moving a number of sovereignsinto a more challengingdebt
sustainability position.
Most likely, what wehave seen is a combination of factors:
(i)a sharp reductionin risk appetite resultingin even little-changeddebt
ratios, asin Italy, lookingmore challengingand in need of a risk-
premium;and in addition(for most countries)
(ii)a sharp increasein debt ratiosasgovernmentsreacted tothecrisis
(including, but not at all confined to, thesocialisationin most countries
of some privatebanking lossesthrough their assumption by
governments) (Figure 4 again).
Theincreasedsensitivityof sovereign spreadstoratings, and the
increasedrangeof ratingsthemselves– both illustratedin Figure 2 –
suggest that both factorsare at work.
(As spreadswidenedin stressedcountries,their fluctuations– which
wouldnot concernhold-to-maturityinvestors– added a risk factor for
othersand probablyratchetedup the averagelevel of the spreads.)
In the specific caseof Ireland, the depth of the recession and the
remarkablyhigh elasticityof tax revenuesand the Government deficit to
thedownturn, combined with theunfortunate decision to lock-in a very
comprehensivebank guarantee beforethepotential scaleof the banking
lossescould at all be appreciated, meant that Ireland‘sactual and
prospectivegeneral government debt made a shockingturnaround from
about 25per cent of GDP in 2007to 117per cent just five yearslater.
Historianswill debatethe exact triggersfor the market‘slossof
confidencein the Irishsovereign.
Even aslate asApril 2010,after the first samplingindicated the scaleof
the banking losses, sovereign spreadswerelittlemore than 1per cent.

By November of that year (just a few weeksafter the Deauvillestatement
whichpersuaded themarketsthat private sector holdersof euro sovereign
debt wouldnot be immune from loss-sharing) largebankingoutflowsand
spreadsexceedingfiveper cent made recoursetoofficial assistance
inevitable.
(Figure 3 showstheplot withsome relevant newsstories flagged).
Perhapsthemost significant take-awayfrom thesequenceof spikes and
troughsis thefact that some of them clearlyrelate to newsthat is
country-specific, some of them to euro area general news.
Thesame is doubtlesstrue for all of the stressedsovereigns.
Default risk vs. devaluation risk vs. redenomination risk
It‘s worthpausing torecall that raw sovereign spreadssuch asweare
seeingtoday in theeuro area are not remotely unprecedentedin pre-euro
history.
On thecontrary, theywerethenorm asisillustrated by Figure1.
Thedifferenceisthat thesespreadsreflecteda combination of default
risk and currency risk.
During the last fiscal crisisof the 1980sIrish sovereign spreadsballooned
out also.
But that wasfor local currencydenominateddebt.
Eurobond borrowingby the Irish Government remained at fairlytight
spreadsdespite thehigh overall debt ratio(higher than today), and the
fact that almost half of thenational debt wasdenominatedin foreign
currency.
Thehigh spreadsreflecteddevaluation expectationsand currencyrisk
generally.

And there weredevaluations,though lessthan wasbaked intothespreads
– bybetween250and 300basispointson averageduring thelast ten
years of that ill-fatedregime, thenarrow-bandEMS.
It is not that default and devaluation are closesubstitutes;not at all, and
for several reasons.
For onething, default haspotential reputational consequencesfor the
issuer qualitativelydifferent tothoseof devaluation.
In addition, though, devaluation affectsnot onlythe international value
of the Government‘sdebt promises,but alsothat of all other contracts
denominatedin local currency; asa result, dependingon thespeedof
price-resetting(pass-through) it can affect competitivenessthroughout
theeconomy.
Thesedifferenceshave not been sufficientlyemphasised, I feel, in recent
discussion.
As an example, I could mention the Irish devaluation ofAugust 1986.
Themain goal of thisimportant action wasrestoration of wage
competitiveness,not a loweringof the real value of the localcurrency-
denominateddebt.
(Indeed, I recall that somedomestic policymakers wereconfused onthis
point and thought that the debt burden wouldactuallyincreaseasa result
of translationeffect on the foreign currencydebt!)
Such currency risk can be so extreme asto make it impossible for the
sovereign to issue any sizable amount of local-currency denominated
debt tointernational lenders.
In the literature,such countries – all in the developingworld(and not
includingIreland, cf. Figure 5) – weresaid to suffer from ―Original Sin‖.

Happily, thenumber of countries suffering―Original Sin‖ hasbeen
diminishingin recent years.
Instead, wehave to acknowledgetheemergencein market pricingof a
new phenomenon, ―redenomination risk‖.
How can werecogniseredenomination risk?
This is not straightforward,not least becausethe term could refer toa
number of different scenarios.
One suggestedwayof approachingthequestion isto useeconometric
estimatesof thecross-sectional determinantsof sovereign spreadsfor
foreign currency-denominated borrowingto predict current spreadsin
stressedeuro area countries:a positiveresidual might suggesta
redenominationrisk premium.
Comparisonsof current spreadsof euro area sovereignsin euroand in
foreign currency-denominated borrowingsprovidesfor an alternative
approach.
My ownfavourite approach is tolook at the co-movement in the time
seriesof euro area country spreads.
Someof thisco-movement can be attributedtofluctuationsin market
risk-appetite;the remainder could be interpreted asa system-wide
redenominationpremium.
This brief summaryalready suggeststhecomplexityand ambiguityof
someof theconceptsinvolved and their measurement.
Evidently, redenomination risk, as imagined by market
commentators, combines default and currency risk in a novel way not
contemplatedbythe Treatythat establishedthe euro area.

TheECB hasmade clear its determinationto dowhat isnecessaryto
preservethe euro and removeunfounded euro break-up premia in
sovereign yields.
TheOMT, designed asa backstop to inhibit negative self-fulfilling
market dynamics, providesthenecessarytools to deliver on that
commitment.
Theprogrammedoesnot gooverboard in thedirection of removing the
incentivefor governmentstomanagetheir financesin such a wayasto
recover and retain theconfidenceof themarket, but it will ensure that
disciplinedgovernmentswill not have to pay spreadsthat could only
reflectmarket concernsabout a system break-up.
As announced, theECB will only buy bondsat theshorter end of the
maturityspectrum, but the OMT can beexpectedtohave an influence
transmittedbymarket forcesthroughout theyield curve, and indeed
spreadshave tightenedright acrossall maturitiessincethe OMT was
announced.
Still, it is not tobe expectedthat theOMT will by itselfrestore the tight
uniformityof spreadsthat prevailed for the first decadeof the euro.
Forcingsuch a tight uniformitywouldnot be generallyconsidered safe
absent more reliablealternativemechanismsfor ensuring disciplined
fiscalpolicy in the countriesconcerned.
Morelikely wouldbe a potentiallyextendedperiod of sovereign spreads
that, albeit narrowerthan at their worst, remain material.
Sovereign spreadsand the banks
That beingso, weneed toaskwhat are the consequencesof these
spreadsfor the restof the economy, and in particular for theoperation of
thebanking system.

Regardlessof the condition of thebalancesheet and the profit and loss
account of the banks, experienceshowshowhard it is for banks in a
jurisdictionwherethesovereign isunder stresstoaccessthemoney
marketson the finest terms.
In essence, themarket fearsthat a stressed sovereigncould in extremis
reachtothe banksasa sourceof last resort financing– if necessary
usingnational legislationto doso.
From such a perspective, providersof fundsto bankswill tend to price-in
thepossibility that, at the margin, they could end up asindirect providers
of fundstoa stressed sovereign.
There aremanyexamplesin historyof this happening, and the
consequencesfor bank fundingcostshave often been severe.
In other words,while wehave all become sensitisedtothe pressure
whichsocializedbankinglossescan placeon thesovereign, marketsare
alsoacutely awareof thepotential damaginglinksin the other direction.
Either way, there areconsequencesfor the funding costsof both the
sovereign and the banks.
Given the scaleof banking in the euro area, even a relativelysmall
differencein fundingcostscan be consequential.
Once again, the Irish situation dramatises what can happen when the
two-way feedback loop between banks and sovereign causes a loss of
accessto risk-freerates.
As is well known, the Irish banks have suffered severe loan lossesin the
aftermath of the bursting of the property price and construction bubble
whichtheyhad soenthusiasticallyfinanced.
Very sizablecapital injections(about 50per cent of GNP from theIrish
Government alone– a sum whichprovedtoogreat to befinanced
without theprotectionof an IMF programme) haveensuredthat the

Irish banksmore than satisfy regulatoryrequirementsonce again, but
their future profitabilityis constrained by theemergenceand likely
persistenceof the sovereignspreads,and the knock-on effect of the
spreadson thebanks‘funding costs.
Euro-arearisk-freeratesare not now themost relevant indicator of the
marginal cost of fundstothe Irish banking sector.
It is, of course, true that the Irishbanks(like thosein other stressed
countries) have beendrawingheavily on ECB refinancingfacilities
during thecrisis, especiallyfollowingthe huge outflowof fundsthat
occurred in early2009and again in the last few monthsof 2010.
This accessto refinancinghasbeen vital tothe continuingoperation
of the bankingsystem, and it hascome at the policyrate.
(Let me mention asan asidea curiousfeature of thecurrent monetary
policy environment in the euro area.
Thetwokey ECB rates– the main refinancingoperationsrateand the
deposit rate – are 75 basispointsand zero, respectively.
Accesstoboth therefinancing and deposit facilitiesare both closeto all-
timehighs.
But in practice, the bulk of the refinancingis goingto banksin the
stressedcountries,while thebulk of thedepositsare placed by banks in
non-stressedcountries.
Tothe extent that thestressed countrieshavetendedto have weaker
economicperformanceduring the crisis, thispattern might be
consideredparadoxical.
But it is of course a reflectionand semi-automatic consequenceof the
fragmentationwhichhasdeveloped in the euro area.

Tobe sure, the ECB policy rateis clearlybelow themarginal cost of
fundsin the stressedcountries.)
But accessto ECB fundsat thepolicyrate is limitedby the availabilityof
eligiblecollateral and thehaircutsthat are appliedtosuchcollateral
(despitethe relaxation of eligibilitycriteria).
About 20 per cent of thetotal financingof the three going concern Irish
controlledbankscomesfrom this sourceat present (16per cent of the
balancesheet total).
Competition for depositsthereforeremainsstrong and rateshigh.
It‘s not just that higher bank funding costswill now be passedon tonew
borrowers,addingheadwindstotheeconomic recovery, though that is
certainlya factor.
Indeed, the lowerpolicy interest ratesset by theECB sincethecrisis
beganhave only been partlytransmittedtoborrowersin Ireland and in
theother stressedeuro area countries(Figure 6).
(As is seen by the resultsof a recursive regression exercise, the pass-
through from policy rate to Irish residential mortgage SVR rates has
halved sincethestart of the crisis– Figure7.)
Someof thiscan be rationalisedasreflectinga higher credit risk-
premium beingcharged by thebanks, but some isalsoduetothehigher
marginal cost of funds.
Worsestill for thehealth of the banks, and their ability tocontributeto
theeconomic recovery, is thefact that theyare still copingwiththe
consequencesof their marginal cost of fundshavingdelinked sosizably
from theECB policyrate.
Theseconsequencesarise becauseof thelong-term mortgagecontracts
thebanks made when theyassumed that their marginal costof funds
wouldalwaysremain closetothe (risk-free) policy rate.

Suffice it to saythat a largeblock of residential mortgageswasgranted at
interest rateswhichtrack the ECB policy rate plusa very lowspread.
Thesetracker mortgages,many of whichhave an averageremaining
maturityof 15–20years or more, yield lessthan themarginal cost of funds
(Figure 8 whichis drawnon the assumption, not strictlyvalid, that the
averagespread of the trackersover policy rate wasunchangedover time).
In effect, by assumingthat their cost of fundswouldnot deviatemuch
from theECB policyrate, thebanks exposedthemselvesto a very large
―basisrisk‖.
In principle, theycould escapethis trap if there werea willingpurchaser
(publicor private) withaccesstofundingat a cost that isnot
contaminatedby thesovereign stress.
Until such a purchaser comesforward, thebankswill have to continueto
fund this portfolio at a loss, even on performingmortgages, whose effects
will spill over ontotheir customersand their owners(not leasttheState).
Conclusion
Irish Sovereign spreadsmay no longer bebloated by redenomination
risk, but at 300basispointsat thelong-end, theydoseem toreflect a
credit risk premium that is poor reward, sofar, for what hasbeen a
sizablefiscal adjustment effort.
Reflectingon wherewehave got to, it seemsthat there aredistinct
parallelswiththe fiscal crisisof the EMS period.
As I mentioned, spreads (then reflectingdevaluation risk) exceededwhat
wouldhave been needed ex post tocompensatefor actual exchangerate
movementsbyalmost thesame amount (250–300basispoints).

Thosespreadsweretransmittedtothe bankingsystem thenalso.
TheIrish financial situationis relatively extreme, and assuch illustrates
clearlysome of the key problemsthat have been facedalsoin other
stressedpartsof theeuro area.
While it hasdelivered a much lowerinflationrate, theeuro is nolonger
insulatingfinancial marketsfrom the impact of excessivedebt in
member countries.
Theearlyinsulationof themonetarytransmissionmechanism from
fiscalproblems of participatingcountrieshas wornthrough.
Theperniciousfeedback loop from banksto sovereign and from
sovereignto banksthat re-emerged in thecrisisremainsstrong and
damaging.
Gettingback to the―good‖ equilibrium will require ahealingprocess
whichremovesthemarket‘sfear of default.
It is inevitablya protracted processneedingnot only firm adherenceto
consistentlydisciplinedpoliciesbut alsothe creationof institutionsthat
can prevent future crises,or at least copewith them better if theycannot
beavoided.

Report from theCommission
tothe European Parliament
andthe Council
The review of the
Directive 2002/87/EC of the European Parliament and the
Council on the supplementary supervision of credit
institutions, insurance undertakingsand investment firms in a
financial conglomerate
1.Introduction and Objectives
1. Background
Therapid development in financial marketsin the1990sledtothe
creationof financial groupsprovidingservicesand productsin different
sectorsof the financial markets, theso-calledfinancial conglomerates.
In 1999, the European Commission‘sFinancial ServicesAction Plan
identifiedtheneed tosupervisetheseconglomerateson a group-wide
basisand announced the development of prudential legislationto
supplement thesectorallegislationon banking, investment and
insurance.
Thissupplementaryprudential supervisionwasintroduced by the
Financial Conglomerate Directive(FICOD) on 20November 2002.
TheDirective followsthe Joint Forum‘s principleson financial
conglomeratesof 1999.
Thefirst revision of FICOD (FICOD1) wasadopted in November 2011
followingthe lessonslearnt during thefinancial crisisof 2007-2009.
FICOD1 amended the sector-specific directivesto enablesupervisorsto
perform consolidated banking supervision and insurancegroup

supervision at the level of theultimateparent entity, even wherethat
entityisa mixed financial holding company.
On top of that, FICOD1 revisedthe rulesfor theidentificationof
conglomerates,introduceda transparencyrequirement for the legal and
operational structuresof groups,and brought alternativeinvestment
fund managerswithinthe scope of supplementarysupervision in the
samewayasasset management companies.
FICOD1‘sArticle 5 requiresthe Commissiontodeliver a review report
before31December 2012addressingin particularthescope of the
Directive, the extension of itsapplicationto non-regulatedentities,the
criteria for identificationof financial conglomeratesowned by widernon-
financial groups, systemicallyrelevant financial conglomerates,and
mandatorystresstesting.
Thereview wasto befollowedup by legislative proposalsif deemed
necessary.
It should be noted that sincetheadoption of FICOD1 some issues,such
asaddressingsystemic importanceof complex groups, and recovery and
resolution toolsbeyond the livingwillsrequirement in FICOD1havebeen
or will be resolvedin other contextsand have thereforebecome less
relevant for this review.
1.2. The purpose of the review and the Joint Forum‘s revised
principles
This review isguided by theobjectiveof FICOD, which is toprovide for
the supplementarysupervision of entitiesthat form part of a
conglomerate, witha focus on the potential risksof
contagion, complexityand concentration — theso-calledgroup risks—
aswell asthe d et ect ion and correct ion of ‗d ou b le gearin g‘ —
themultipleuse of capital.
Thereview aimstoanalyse whetherthecurrent provisionsof

FICOD, in conjunction withtherelevant sectoralruleson group and
consolidatedsupervision, areeffectivebeyond theadditional provisions
introduced by FICOD1.
Thereview is justifiedasthemarket dynamicsin which conglomerates
operatehave changed substantiallysincetheDirective entered intoforce
in 2002.
Thefinancial crisisshowed how group risksmaterialisedacrossthe
entire financial sector.
This demonstratesthe importanceof group-widesupervision of such
inter-linkageswithinfinancial groupsand among financial
institutions,supplementingthesector specific prudential requirements.
Thelimitedapproach of FICOD1 waspartiallybasedon the anticipation
of the Joint Forum‘s revisedprinciples,whichweredue to beaddressed
in thepresent review.
Theseprincipleswerepublishedin September 2012withthetwomain
issuesbeingthe inclusionof unregulatedentitieswithin thescope of
supervision to cover the full spectrum of risks to whicha financial group
is or may be exposed and the need toidentify the entityultimately
responsiblefor compliancewiththe group-wide requirements.
This review takesthe revisedprinciplesduly intoaccount together with
theevolving sectoral legislationaspresented below.
1.3. Evolving regulatory and supervisory environment
FICOD rulesare supplementary in nature.
Theysupplement therulesthat credit institutions,insurance
undertakingsand investment firms aresubject toaccordingto the
respectiveprudential regulations.

Currentlythis sectoral legislationisbeingoverhauledin a major wayand
theregulatoryenvironment is evolving.
TheCRD IV and OmnibusII are pending proposalsbeforethe
European Parliament and the Council, and Solvency II includes
enhancedgroup supervisionprovisionswhich arenot yet applicable.
Once theseprovisionsare applicable, the Commission will closely
monitorthe implementationof these new frameworks,which also
comprise a number of delegated and implementingacts, including
regulatorytechnical standardsto be developedover a number of years by
the Commission and theEuropean supervisoryauthorities(ESAs).
In addition, thechangesrecentlymade toFICOD will not bein place
beforemid-2013,socannot yet be fullyexamined in practicebeforelate
2014.
Theseincludethe regulatoryand implementingtechnical standardsand
common guidelinestobe issued by theESAs.
Finally, the BankingUnion Regulation proposal callsfor a major change
in thesupervision of Europeanbanksand will have an impact on the
supervision of conglomeratesasone of the tasksconferred tothe
European Central Bank wouldbe to participatein supplementary
supervision of a financial conglomerate.
As this report shows, there are areasof supplementarysupervision where
improvementscould be made.
However, as with any legislation, the benefits of amending legislation
always have to be weighed against the costs connected with legislative
changes.
Accordingtothe European Committee on Financial Conglomeratesat its
meetingon 21September 2012,the supervisorycommunitythrough the
ESA‘sadvice to theCommission, and theindustry in itsresponsesto the
consultationcarried out by theCommission, the optimal timing for

revisingFICOD will only be oncethe sectoral legislationhasbeen
adopted and is applicable.
2.The Scope of the Directive and the Legal Adressees of the
Requirements
1. Scope
1.The scope of FICOD and the sectoral legislation
Most of thegroupsoperatingin the financial sector have a broad
spectrum of authorisations.
Focusingon the supervisionof onlyone type of authorised entity ignores
other factorsthat may have a significant impact on the risk profileof the
group asa whole.
Fragmented supervisoryapproachesare not sufficient to cope with the
challengesthat current group structuresposetosupervision.
Thesupplementarysupervision framework for conglomeratesis meant
tostrengthen and completethe full set of rules applicableto financial
groups,acrosssectorsand acrossborders.
However, from a regulatory standpoint, additional layers of supervision
have to be avoided when the sectoral requirements already cover all the
typesof risk that may arise in a group.
2.Coverage of unregulated entities, including those not
carrying out financial activities
In order toaddressgroup risks,whichwasthe original aim of FICOD
andtheJoint Forum principles,asre-affirmedby the revised
principles,group supervision should cover all entitiesin the group which
arerelevant for the risk profile of theregulatedentitiesin thegroup.

This includesanyentitynot directlyprudentiallyregulated, even if it
carriesout activitiesoutsidethe financial sector, includingnon-regulated
holdingand parent companiesat thetop of the group.
Each unregulated entitymay present different riskstoa conglomerate
and eachmay require separate considerationand treatment.
Among unregulatedentities,special importanceis attachedtospecial
purpose entities(SPEs).
Thenumber of SPEsand thecomplexityof their structuresincreased
significantlybeforethefinancial crisis, in conjunction with thegrowthof
marketsfor securitisationand structuredfinanceproducts,but have
declinedsincethen.
While theuse of SPEs yieldsbenefits and may not be inherently
problematic, the crisis hasillustrated that poor riskmanagement and a
misunderstandingof the risksof SPEs can lead todisruptionand failure.
Theneed for enhancedmonitoring of intra-grouprelationshipswith
SPEs washighlightedin the Joint Forum‘s2009SPE report.
2.1.3. Coverage of systemically relevant financial conglomerates
Thechallengesof supervisingconglomeratesare most evident for
groupswhosesize, inter-connectednessand complexitymake them
particularlyvulnerableand a sourceof systemic risk.
Any systemically important financial institution (SIFI) should in the first
placebe subject to more intensesupervisionthrough application of the
CRD IV and SolvencyII framework, both at individual and group
/ consolidatedlevel.
If the SIFI is alsoa conglomerate, supplementarysupervisionunder
FICOD wouldalsobe applicable.

Although most SIFIsare conglomerates,thisis not alwaysthecase.
Also, systemic risksare not necessarilythesame asgroup risks.
Therefore, it doesnot seem meaningful totry tobring all SIFIsunder
FICOD.
Furthermore, discussionsat international level are still continuing on
insuranceSIFIs, and the sectoral legislation, includingthe treatment of
bankingSIFIs, is not yet stable.
2.1.4. Thresholds for identifying a financial conglomerate
All theissuesmentioned above are linkedto thedefinitionof a
conglomerateand the thresholdsfor identifying one.
Thetwothresholdsset out inArticle 3of FICOD take intoaccount
materialityand proportionalityfor identifying conglomeratesthat should
besubject tosupplementarysupervisionof group risks.
Thefirst threshold restrictssupplementarysupervision to those
conglomeratesthat carryout businessin the financial sector and the
second restrictsapplicationtoverylargegroups.
Thecombined applicationof the twothresholdsand the use of the
availablewaiverby supervisorshave led toa situation wherevery big
bankinggroupsthat are alsoseriousplayers in theEuropean insurance
market are not subject to supplementary supervision.
Furthermore, the wordingof the identificationprovisionmay leaveroom
for different waystodeterminethe significanceof cross-sectoral
activities.
It couldbe improved to ensure consistent application acrosssectorsand
borders.

Toensure legal clarity, it is important tohaveeasilyunderstandableand
applicablethresholds.
However, the question remainswhetherthethresholdsand thewaivers
should be amendedor complementedtoenablesupervisionin a
proportionateand risk-basedmanner.
2.1.5. Industrial groupsowning financial conglomerates
While there is agreement that regulatedfinancial entitiesareexposed to
group risksfrom thewiderindustrial group towhichtheymight
belong,no conclusion can be drawnat thisstageasto how to extend the
FICOD requirementstowidernonfinancial groups.
TheFICOD1 review clauserequired the Commissionto assesswhether
theESAsshould, through the Joint Committee, issueguidelinesfor
assessment of thematerial relevanceof the activitiesof these
conglomeratesin the internal market for financial services.
Currentlythere isnolegislationon thesupervision of industrial groups
owningfinancial conglomeratesand theESAshave noempowerment to
issueguidelines.
Therefore, whilethe ESAswill certainlyplaya keyrolein ensuring the
consistent application of FICOD, it is premature toreach any
conclusionson theneed for theESAsto issueguidelineson this specific
topic.
2.2. Entities responsible for meeting the group-level
requirements
Imposingrequirementsat group level will not ensurecomplianceunless
thisis accompaniedby clear identificationof the entityultimately
responsiblein the financial group for controllingriskson a group-wide
basisand for regulatory compliancewithgroup requirements.

This would allowmore effectiveenforcement of therequirementsby the
supervisoryauthorities(discussed in section 4below).
Interaction withcompany law provisionsgoverningthe responsibilities
of the ultimatelyresponsibleentityneedsto be takenintoconsideration.
This ultimateresponsibilitymight need to be extendedtonon-operating
holdingcompaniesat the head of conglomerates,even though a limited
scopemay be envisagedfor thoseholding companieswhoseprimary
activityis not in thefinancial sector.
3.Provisions Needed to Ensure the Detection and Control of
Group Risks
Theobjectiveof supplementarysupervisionis to
detect, monitor, manageand control group risks.
The current requirements in FICOD concerning capital adequacy
(Article 6), risk concentrations (Article 7), intra-group transactions
(Article 8) and internal governance (Articles 9 and 13) are meant to
achievethisobjective.
Amongst other criteria, theyshould be assessedagainst theneed to
strengthen the responsibilityof the ultimate parent entityof
conglomerates.
1. Capital (Article 6)
Thecapital requirementsfor authorisedentitieson a stand-aloneand
consolidatedbasisare definedby thesectoral legislation dealingwiththe
authorisationof financial firms.
Article 6 of FICOD requires supervisorstocheck the capital adequacyof
a conglomerate.

Thecalculationmethodsdefined in that Article aim to ensurethat
multipleuseof capital is avoided.
The JCFC‘s Capital Advice from 2007 and 2008 revealed a wide range of
practices among national supervisory authorities in calculating available
and required capital at the level of the conglomerate.
Thedraft regulatorytechnical standard (RTS) developed under FICOD
Article 6(2), publishedfor consultationon 31August 2012,specifiesthe
methodsfor calculatingcapital.
Thetechnical standard is expectedtodeal sufficientlywiththe
inconsistent useof capital calculationmethodsfor thepurposeof
regulatorycapital requirementsand toensure that onlytransferable
capital is counted asavailable for the regulated entitiesof the group.
Indeed, asthisRTS should ensure a robust and consistent calculationof
capital acrossMember States,when negotiatingtheCRD IV proposal, it
appearedthat nochangestoFICOD toaddressBaselIII objectives
regardinga potential double countingof capital investmentsin
unconsolidatedinsurance subsidiarieswerenecessary.
However, the discussionsaccompanying thedevelopment of this
technicalstandard revealed further concerns regarding group-wide
capital policy.
Supervisorssometimeslack insight intothe availability of capital at the
level of theconglomerate.
This could be addressed by requestingthe supervisoryreportingand
market disclosure of capital on an individual or sub-consolidated basisin
additiontothe consolidatedlevel.

2.Risk concentrations(Article 7) and intra-group transactions
(Article 8)
Articles7 and 8 on riskconcentrationsand intra-group transactionsset
out reporting requirementsfor undertakings.
Combined withthe potential extensionof supervision to unregulated
entitiesand identificationof the entityultimately responsiblefor
compliancewith FICOD requirements,includingreporting
obligations,theserequirementsshould providean adequate framework
for supplementarysupervisionwithregard torisk concentrationsand
intra- group transactions.
Theguidelinestobe developed by ESAs, asrequested by
FICOD1, should ensure that the supervision of risk concentrationsand
intra-grouptransactionsis carried out in a consistent way.
3. Governance (Articles9 and 13)
Given the inherent complexityof financial conglomerates,corporate
governanceshould carefullyconsider and balancethe combinationof
interestsof recognizedstakeholdersof the ultimateparent and the other
entitiesof thegroup.
Thegovernancesystem should ensurethat a common strategy achieves
that balanceand that regulatedentitiescomplywithregulation on an
individual and on a group basis.
FICOD, asamended, containsa requirement for conglomeratestohave
in placeadequate risk management processesand internal control
mechanisms, a fit and proper requirement for thosewhoeffectivelydirect
thebusinessof mixed financial holding companies,a ‗livingwill‘
requirement, a transparencyrequirement for the legal and organisational
structuresof groups, and a requirement for supervisorstomake the best
possibleuseof the availablegovernancerequirementsin CRD and
SolvencyII.

CRD III and theproposal for CRD IV require, aswill SolvencyII, further
strengtheningof corporategovernanceand remuneration policy following
thelessonslearnt during the crisis.
Thelivingwill requirement in FICOD1 wouldbe strengthenedby the
Bank Recovery and Resolution Framework.
What these frameworksdonot yet cover is the enforceableresponsibility
of the head of the group or therequirement for thislegal entityto be
readyfor any resolution and toensure a sound group structure and the
treatment of conflictsof interest.
TheBank Recovery and Resolution Framework wouldrequire the
preparation of group resolution planscoveringthe holding companyand
the banking group asa whole.
4. Supervisory Tools and Powers
1.The current regime and the need to strengthen supervisory
tools and Powers
Article 14 enablessupervisorstoaccessinformation, alsoon minority
participations,whenrequired for supervisorypurposes.
Article 16 empowersthecoordinatortotake measureswithregard to the
holdingcompany, and the supervisorsof regulated entitiestoact against
theseentities,upon non-compliancewithrequirementsconcerning
capital, risk concentrations,intra-grouptransactionsand governance.
TheArticle only refersto ‗necessarymeasures‘to rectify the
situation, but doesnot specify such measures.
OmnibusI gavetheESAsthe possibilitytodevelop guidelinesfor
measuresin respect of mixed financial holdingcompanies,but these
guidelineshave not yet been developed.

Article 17 requires Member Statesto provide for penaltiesor corrective
measuresto be imposed on mixed financial holding companies or their
effectivemanagersif they breach provisionsimplementingFICOD.
TheArticle alsorequires Member Statesto confer powerson supervisors
toavoid or deal with the circumvention of sectoral rulesby regulated
entitiesin a financial conglomerate.
ThewordingofArticle 16and the lack of guidelineshave led to a
situation wherethereis noEU-wideenforcement frameworkspecifically
designedfor financial conglomerates.
As a result, the supervisionof financial conglomeratesis sectorallybased
with differencesin national implementation.
Furthermore, the ESAs point out that strengtheningthesanctioning
regimeasadvocatedin the CRD IV proposalmay createan uneven
playing field betweenfinancial conglomeratesdepending on whether
theyare bank or insurance-led.
At the same time, accordingto theESAs, most national supervisory
authoritiesconsider that the measuresavailablefor sectoral supervision
are equallyappropriate for the supervisionof financial conglomerates.
Strengtheningthesupervision of financial conglomeratescould therefore
beachieved by improvingthe actual useof the existinginstruments.
As to theArticle 17 requirement for Member Statestoprovidefor
crediblesanctionstomake the requirementscrediblyenforceable,no
such sanctioningregimeis known for conglomerates.
TheESAs provide eight recommendationsboth to enhancethe powers
andtoolsat the disposal of supervisorsand tostrengthen enforcement
measures,alsotaking intoaccount thedifferencesin national
implementation.

Thoserecommendationsincludeestablishingan enforcement regime for
theultimatelyresponsibleentityand itssubsidiaries.
This impliesa dual approach, withenforcement powerstodeal withthe
top entityfor group-widerisksand tohold theindividual entitiesto
account for their respectiveresponsibilities.
In addition, thesupervisor should have available a minimum set of
informativeand investigativemeasures.
Supervisors should be able to impose sanctions upon mixed activity
holding companies, mixed activity insurance holding companies or
intermediatefinancial holdingcompanies.
4.2. The possibility to introduce mandatory stresstesting
Thepossibilityto require conglomeratesto carryout stresstestsmight
bean additional supervisorytool to ensure theearlyand effective
monitoring of risks in the conglomerate.
FICOD1 introducedthe possibility (though not an obligation) for the
supervisortoperform stresstestson a regular basis.
In addition, whenEU-widestresstestsare performed, the ESAs may
take intoaccount parametersthat capture thespecific risksassociated
with financial conglomerates.
5. Conclusion
Thecriteria for the definition and identificationof a conglomerate, the
identificationof theparent entityultimatelyresponsiblefor meetingthe
group-widerequirementsand the strengtheningof enforcement with
respect tothat entityare themost relevant issuesthat could beaddressed
in a future revision of the financial conglomeratesdirective.
Theidentificationof the responsibleparent entitywould alsoenhance
theeffectiveapplication of theexistingrequirementsconcerning capital

adequacy, risk concentrations,intra-grouptransactionsand internal
governance.
Theregulatoryand supervisory environment with regard tocredit
institutions,insuranceundertakingsand investment firms is evolving.
All thesectoral prudential regulationshave been significantlyamended
on several occasionsin thelast few years, and evenmore significant
changestothe regulatoryrulesare pendingbefore the legislators.
Furthermore, theproposal for the Banking Union significantlychanges
thesupervisory framework.
Therefore, and takingintoaccount alsothe position of the European
Financial ConglomeratesCommittee, thesupervisorycommunity and
theindustry, the Commissionconsidersit advisablenot toproposea
legislativechangein 2013.
TheCommission will keep the situationunder constant review to
determinean appropriate timingfor therevision.

EU-U.S. Dialogue Project
Technical Committee Reports
Comparing CertainAspectsof the
InsuranceSupervisory and Regulatory
Regimesin the European Union and the UnitedStates
Important parts
TheSteeringCommitteeof the EU-U.S. Dialogue Project presents
herewiththe final reportsof seventechnicalcommitteescomparing
certainaspectsof the insurancesupervisoryregimesin the European
Union and theUnited States.
Attached isbackground information on the Project and the reports
themselves.
Thereportsinformed the Steering Committeeasto the key
commonalitiesand differencesbetweenthe EU‘s insuranceregulatory
and supervisory regime and thestate-basedinsuranceand regulatory
regimein the U.S.
TheSteeringCommitteehasagreed to common objectivesand
initiativesto be pursued over thenext five years which are set out in the
Way Forward document availableat
[https:// eiopa.europa.eu/ publications/reports/index.html].
TheSteeringCommitteeacknowledgesthe valuablecontributionsof the
technicalcommitteemembers and thosewho provided commentsduring
thepublic consultation process.

Introduction to the EU-U.S. Dialogue Project
In the EU, the European Parliament, the Council of the European Union
andtheEuropean Commission (EC), technicallysupportedby the
European Insuranceand Occupational PensionsAuthority (EIOPA), are
modernizingtheEU‘s insurance regulatory and supervisory regime
through the SolvencyII Directive(Directive 2009/138/EC), in place since
2009.
This so-calledFramework Directivewasthe culmination of workbegun
in the1990stoupdateexistingsolvencystandardsin the EU.
Current work aims to further specify the Framework Directive with
technical rules and guidelines, which are necessary for a consistent
application byinsurersand supervisorsof the framework.
In the United States,the statesare the primary regulatorsof the
insuranceindustry.
Stateinsuranceregulatorsare membersof theNationalAssociation of
InsuranceCommissioners(NAIC), a standard-settingand regulatory
support organizationcreatedand governedbythe chief insurance
regulatorsfrom the50states,the District of Columbia and five U.S.
territories.
As part of an evolutionary process, through the NAIC, state insurance
regulatorsin the U.S. are currentlyin the processof enhancingtheir
solvencyframeworkthrough theSolvencyModernizationInitiative
(SMI).
SMI is an assessment of theU.S. insurancesolvencyregulation
frameworkand includesa review of international developments
regardinginsurancesupervision, bankingsupervision, and international
accountingstandardsand their potential usein U.S.insurance
regulation.

In early2012,theEC, EIOPA, theNAIC and the Federal Insurance
Office of theU.S.Department of the Treasury(FIO) agreed to
participatein dialogueand a relatedproject (Project) to contribute toan
increasedmutual understanding and enhancedcooperation betweenthe
EU and the U.S.to promotebusinessopportunity, consumer protection
and effectivesupervision.
Theproject is considered to be part of and buildson the on-goingEUUS
Dialoguewhichhasbeen in placefor over 10years.
Theworkwascarriedout in collaborationwithEIOPAand competent
authoritiesin theEU Member States,and withstate insuranceregulators
andtheNAIC in theUnitedStates.
Theobjectiveof theProject isto deepen insight intothe overall
design, functionand objectivesof the keyaspectsof thetwo
regimes,and toidentify important characteristicsof both regimes.
Project Governanceand Process:The Project is led by a six-member
SteeringCommitteecomprised of three EU and three U.S.officials,as
follows:
- Gabriel Bernardino– Chairman of EIOPA
- Edward Forshaw – Manager in the Prudential Policy division, UK
Financial Services Authority, and EIOPA Equivalence Committee
Chair
- Karel Van Hulle– Head of Unit for Insuranceand
Pensions,Directorate-GeneralInternal Market and
Services, EC
- Kevin M. McCarty– Commissioner, Office of Insurance
Regulation, Stateof Florida, and current President of theNAIC
- Michael McRaith– Director, FIO, United StatesDepartment of the
Treasury

-ThereseM. (Terri) Vaughan – Chief Executive Officer, NAIC
Sincethe Project began, theSteering Committeeheld face-to-face
meetingsin Basel, Brussels,Frankfurt and Washington DC, aswellas
numerousconferencecalls.
In a first step, thetopics tobe discussedwereagreed upon and a process
for information exchangeunder confidentialityobligationswas
established.
TheSteeringCommitteeagreed upon seventopics fundamentally
important toa sound regulatory regimeand totheprotection of
policyholders and financial stability.
Theseven topicsare:
- Professional secrecy/ confidentiality;
- Group supervision;
- Solvencyand capital requirements;
- Reinsuranceand collateral requirements;
- Supervisoryreporting, data collection and analysis;
- Supervisorypeer reviews;and
- Independent third partyreview and supervisoryon-site inspections.
AseparateTechnical Committee(TC) wasassembledto addresseach
topic.
Each TC wascomprised of experiencedprofessionalsfrom both the
European Union aswell asthe United States,specifically, from FIO, the
EC, theNAIC and EIOPA, aswell asrepresentativesfrom state

insuranceregulatoryagenciesin the UnitedStatesand competent
authoritiesof EU Member States.
Thevariousprofessionalswhocomprised the technical committeeswere
selectedbecauseof their qualificationsand experiencewith respect tothe
subject matter of each topic, includinginsuranceregulatorsand
supervisors,attorneys, accountants,examiners,and other specialists.
Theteamsworked jointlyto develop objective,fact-basedreports
intendedto summarize the key commonalities and differencesbetween
theSolvencyII regime in theEU, and thestate-based insurance
regulatoryregime in the United States.
Supportingdocumentation, e.g., regulations,directives,and supervisory
guidance,wasexchangedasrequested by either side.
Theaccompanying seventechnical committeereportswerejointly
drafted to reflect theconsensusviewsof each respectivetechnical
committee‘smembers.
Thedraft reportsweresubsequentlyreleasedfor public consultation. The
writtenconsultation wascomplementedby twopublic hearings held
in October 2012,onein Washington DC and another in Brussels.
Basedon oral and writtencommentsreceived through the consultation
process, factual inaccuraciesnoted in thedraft reportswerecorrected
and limited clarificationsweremade.
Thereportswerenot amended further despiterecommendationstodoso
bysome commenters, i.e., thescope of theProject wasnot expandedas a
result of the consultationprocess.
Notwithstandingthis, all oral and writtencommentshavebeen taken
intoconsideration in theSteeringCommittee's deliberationsaspart of
thesecond phaseof the project.

No action hasbeen taken by the governing bodies of theorganizations
represented on the SteeringCommitteetoformallyadopt thefactual
reportsand thusthis document should not beconsidered to express
official viewsor positionsof any organization.
Thereportsrepresent the culmination of workfrom theProject, and
informed the work of the SteeringCommitteein agreeingtothe
aforementionedcommon objectivesand initiatives.
Adetailedproject plan will be developed in early2013and will be
updatedperiodically.
Theinformationthat is thesubject of the accompanying seven reports
pertainsto the insuranceregulatory and supervisoryregimesin both the
EU and the UnitedStates.
Thestatebasedapproach in the U.S.asdescribed in thereportsis in some
respectsbased on NAIC Model lawsand regulationsthat are given effect
onlythrough legislativeenactment in each respectivestate.
While some of thesemodel lawshave yet tobe adopted and implemented
in certain states,a core set of common solvencyregulatorystandardsare
in placein all states.
In the caseof the EU, the approachdescribedin the reportsis largely
based on the approachset out in the SolvencyII Directive.
However, in order toensure a comprehensive comparison withtheState-
based Regimein the U.S., referenceis alsomade in some casestothe
approachenvisagedfor the technicalrulesthat will implement the
Directive.
It is important to note that thosetechnical rulesare still under
development and have yet to be adopted by theEuropean Commission
in theform of delegatedacts.

Theserulesand certain NAIC models are in some instancesreferred to
in the present tensein the Technical Committees‘ reports,i.e., asif they
are currentlyin place, eventhough theyhavenot yet been adopted or
implemented, withrespect totheserulesin the EU or, in thecaseof the
model lawsin theUnited States,by all states.
Thereport doesnot purport torepresent or pre-judgethe viewsand/ or
theformal proposalsof the Commission.
Theapproach described islargely basedon what wastestedin the last
full quantitativeimpact study (QIS5), the technical specificationsfor
whicharepublicly available.
Insuranceis a specializedand complex industry, and insurance
regulatoryand supervisorymatterscan be just asspecializedand
complex.
Terminologyused in the reportsreflectsthebackground of the
respectivemembersof each technicalcommittee,and thusthe
terminology and writingstylesmay vary somewhat from onecommittee
report toanother.
TheSteeringCommitteeexpectsthat interestedpartieswhomay have an
interest in theProject and in submittingcommentsare familiar withthe
insuranceindustry and itsregulation in the EU, the U.S., or both.
Accordingly, thetechnical committeeshaveendeavoured to prepare
their reportsin a manner that is appropriate for their own purposesand
that of the SteeringCommittee.
There is some technical terminologythat is used in the reports
and, whereconsideredappropriate, definitionshave been provided
therein.
Sometermsareunique to the U.S. and theEU but have the same
meaning, for example, insurersand undertakings;and reservesand
technicalprovisions.

Other termsexistin both the U.S. and theEU, e.g., review, audit or
ORSA, but differ in content/ substance.
Numerousabbreviationsand acronymshavebeen used throughout the
sevenreports,definitionsof which havebeen includedin a separate
appendix for theconvenience of readers.
Thetext of thisreport can be quoted but only withadequateattribution
tothe sourcedocument.
The Contributing Parties
The Federal Insurance Office, U.S. Department of the Treasury
TheFederal InsuranceOffice (FIO) of the U.S.Department of the
Treasurywasestablishedby the Dodd-Frank Wall Street Reform and
Consumer ProtectionAct.
TheFIO monitorsall aspectsof theinsurance industry, including
identifying issuesor gapsin the regulationof insurersthat could
contributeto a systemic crisisin the insurance industry or theUnited
Statesfinancial system.
TheFIO serveson the U.S. Financial StabilityOversight Council.
TheFIO coordinatesand developsU.S.Federal policy on prudential
aspectsof international insurance matters,includingrepresentingthe
UnitedStates,asappropriate, in the InternationalAssociation of
InsuranceSupervisors.
The FIO assists the Secretary in negotiating certain international
agreements, and serves as the primary source for insurance sector
expertisewithin the Federal government.
TheFIO monitorsaccessto affordableinsuranceby traditionally
underserved communitiesand consumers, minorities,and low- and
moderate-incomepersons.

TheFIO alsoassiststheSecretary in administeringthe Terrorism Risk
InsuranceProgram.
The European Commission
TheEuropean Commission (EC) is one of the main institutionsof the
European Union.
It representsand upholdstheinterestsof the EU asa whole.
TheEC is theexecutive branchof the EU and isresponsiblefor
proposingnew European lawstoParliament and theCouncil.
TheEC overseesand implementsEU policiesby enforcing EU law
(together withtheCourt of Justice), and representstheEU
internationally, for example, bynegotiatinginternational trade
agreementsbetweentheEU and other countries.
It alsomanagestheEU'sbudget and allocatesfunding.
The27Commissioners,one from each EU country, providethe
Commission‘spolitical leadership duringtheir 5-year term.
The National Association of Insurance Commissioners
TheNationalAssociation of InsuranceCommissioners(NAIC) is the
standard-settingand regulatory support organizationcreatedand
governedby the chief insuranceregulatorsfrom the 50states,the
District of Columbia and five U.S. territories.
Throughthe NAIC, state insuranceregulatorsestablish standards and
best practices, conduct peer review, and coordinatetheir regulatory
oversight that is exercisedat thestatelevel.

NAIC staff supportstheseeffortsand representsthe collectiveviewsof
stateregulatorsdomesticallyand internationally.
NAIC members, together withthecentral resourcesof the NAIC, form
the national regime of state-based insuranceregulation in theUnited
States.
European Insurance and Occupational PensionsAuthority
TheEuropean Insuranceand Occupational PensionsAuthority
(EIOPA) wasestablishedasa result of thereforms tothe structure of
supervision of the financial sector in theEuropean Union.
The reform wasinitiated by the EC, following the recommendations of a
Committee of Wise Men, chaired by Mr. de Larosière, and supported by
theEuropean Council and Parliament.
EIOPA technicallysupportsthe EC, amongst others, in the
modernizationof the EU‘s insuranceregulatory and supervisoryregime.
Current workaimstofurther specify the SolvencyII Framework
Directivewithtechnical rules and guidelines,whichis necessaryfor a
consistent application by insurersand supervisorsof the framework.
In cross-bordersituations,EIOPA alsohasa legallybindingmediation
roleto resolvedisputesbetweencompetent authoritiesand may make
supervisorydecisionsdirectlyapplicabletothe institution concerned.
EIOPA is part of theEuropeanSystem of Financial Supervision
consistingof three European supervisoryauthorities, the othersbeing
thenational supervisoryauthoritiesand theEuropean Systemic Risk
Board.
EIOPA is an independent advisorybody to theEC, theEuropean
Parliament and theCouncil of theEuropean Union.

EIOPA‘score responsibilitiesare tosupport thestabilityof the financial
system, transparencyof marketsand financial productsaswell asthe
protection of insurancepolicyholders, pension schememembers and
beneficiaries.
Other Contributing Parties
TheSteeringCommitteeof this DialogueProject gratefullyrecognizes
thecontributionsof their organization‘sstaff, of insurancesupervisors
and regulatorsfrom variousEU Member Statesaswell asfrom various
stateinsurancedepartmentsin the United Stateswhoserved on the
varioustechnical committees.
The Technical Committee Reports
In developing their reports, the Technical Committeesacknowledged
theoverall policyobjectiveof insuranceregulation, the protectionof
policyholders.
Both regimesaim toensure the ongoing solvencyof domesticinsurance
and reinsurancecompanies.
Additional regulatory objectives include facilitating an effective and
efficient marketplace for insurance products, and ensuring financial
stability.
Theseoverarchingpolicy objectives– which arecommon toboth the
state-based regime in theU.S.aswellastheEU regime – providea
foundation for each of the accompanying seven reports.
In addition, theSteering Committeeacknowledgesthat each solvency
regimemust be consideredfrom a holistic perspectiveand isalso
mindful that differencesbetween the respectiveregulatory frameworks
are in some casesattributabletodifferent philosophical approachesand
legal foundations.

For example, thedifferent solvencytoolsoutlinedin the Technical
Reportsare usedtovarying degreesbyeach regime.
Such differenceswill be considered asappropriatein thesecond phaseof
theProject, but, apart from the inclusion of cross-referencesbetweenthe
topics, it wasdeemed to be beyond thescope of the Project tomake
further amendmentsto the individual Technical Committee reportsin this
regard.
Thereport givesnonethelessa comprehensiveoverview of thekey parts
of both regimeseven if depictedseparately.
Thestate-basedsolvency regime in theU.S. is basedon 7 core
principles, asfollows:
- Principle1: Regulatoryreporting, disclosure and transparency
- Principle2: Off-siteMonitoring andAnalysis
- Principle3: On-siteRisk-focusedExaminations
- Principle4: Reserves,CapitalAdequacy and Solvency
- Principle5: RegulatoryControl of Significant, Broad-basedRisk-
related Transactions/ Activities
- Principle6: Preventiveand CorrectiveMeasures,including
enforcement
-Principle7: Exitingthe Market and Receivership
TheEU Solvency II followsa three pillar approach.
- Pillar I: Quantitativerequirementsrelatingto valuationof assetsand
liabilities,includingtechnical provisions,thequalityof own funds
and Minimum and SolvencyCapital Requirements

- Pillar II: System of Governanceand risk management requirements
- Pillar III: Supervisory reportingand public disclosure
There arecommonalitiesaswell asdifferencesbetween the Core
Principlesidentified in the U.S. state-basedregime‘sInsuranceFinancial
SolvencyFramework and thethree pillar approachof SolvencyII.
Thereportsof the TechnicalCommitteeswhichfollowhighlight the
key commonalitiesand differencesfor eachof the seven topical areas
selectedfor them bytheSteeringCommitteeto review.
Each technical committeefocusedon only one of the aforementioned
topics.
In practice, theregulatory aspectsthat arethe topic of each respective
technicalcommitteereport operateon an integratedbasis,aswellas
with other regulatorytools and powersthat are not coveredby the
accompanyingreports.
Whereappropriate, the report of a technical committeemakesreference
tothe reportsof oneor more other technicalcommittees.
For example, a referencein any one of theaccompanying reports to
―TC3‖ meansthereport of Technical Committee3, whichis listedin the
Tableof Contentsof thiscombined document as―3. Solvencyand Capital
Requirements.‖
Thereportsof thetechnical committeesrefer tovariousEU directives
and regulations,aswell asto variousNAIC model lawsand regulations.
In the EU, a directiveis a legal act that lays down certain end resultsthat
must be achievedin every Member State.
National authoritieshavetoadapt their lawstomeet thesegoals,but are
freetodecidehow todo so.

In caseof maximum harmonization directives,Member Statesmay not
foreseerequirementsother than thoselaid downby the Directive.
EU regulationsare themost direct form of law;assoonastheyare
passed, theyhave binding legal force throughout everyMember State, on
a par with national laws.
National governmentsdonot have totakeactionthemselvesto
implement EU regulations.
Regulationsare passed either jointlyby the Council of the European
Union and European Parliament, or in some specific areas,by the
Commission alone.
Thestate-basedregime in the U.S., through theNAIC, utilizesmodel
lawsand regulationsdeveloped by stateinsuranceregulators.
Although thesemodel lawsand regulationsrequire statelegislative
enactment to becomeeffective,a coreset of solvencyregulation
standardsare effectivelyobligatoryby operation of theNAIC
AccreditationProgram.
Although the statesare primarily responsiblefor the regulation of
insurancein the U.S., certain federal lawsreferencedherein may also
applytoinsurersor specific insuranceactivities.
1. Professional Secrecyand Confidentiality
Executive summary
- TC1organised itsanalysisof the keycommonalitiesand differences
byfocusing on theanalysisof the followingsubjects:
policy objectivesof confidentialitylaws;
therelationship betweenfreedom of informationlawsand insurance
confidentialitylawsin the U.S. and the EU;

theroleof theNationalAssociation of InsuranceCommissioners
(NAIC), the European Insuranceand Occupational Pensions
Authority (EIOPA) and theFederal InsuranceOffice (FIO) asdistinct
from insuranceregulators/ supervisorsin the U.S.statesand EU
Member States;
authoritytoshare information acrossborders and the lawsassociated
with informationexchanges,methodsfor exchanging
information, such asMemorandaof Understanding(MoUs) and
confidentialityagreements, and the confidentialityof non-public
supervisoryinformation receivedby theFIO.
- Both regimesseek tobalancethe objectiveof maintaining
professional secrecywith appropriate flexibilityto share information
with other supervisory authoritieswitha legitimateand material
interest in theinformation.
Against thiskey commonality, key differencesin structural approach
can be observed.
In the EU, the basic presumption incorporated in insurance
legislationis that virtuallyall informationacquired by the supervisory
authoritiesin the courseof their activitiesis bound by the obligation
of professional secrecy.
Aseriesof ―gateways‖ then facilitatesinformationexchangewith
other relevant authorities.
In the U.S., statelawsgenerallyprovide for the confidentialityof
certain information submittedto, obtained by, or otherwisein the
possession of an insurancedepartment.
Theapproach is more often focused on protectingspecific
information from beingavailablefor public inspection.

- Freedomof information (FOI) lawsconcerninggovernment records
and actionsare premised on public accesstoofficial actions.
In both the EU regime and the state based regimein theU.S., laws
expressthe general policy of public accessto government
information, but thispublic policy is qualified by specificprotections
from disclosure for certaincategoriesof information.
Theresult is that both regimesprovide for broad confidentiality
protectionsfor sensitiveinformationwhileallowingfor thesharing of
that information among regulatorsin appropriatecircumstances.
- In both regimes, primary regulatory responsibility rests with the
various state insurance departmentsin the U.S. and with the EU
MemberState supervisoryauthorities, respectively.
Thefunctionsof both setsof supervisorsare supplemented by the
NAIC in the U.S.and EIOPAin the EU.
TheNAIC and EIOPA, in varying ways,assist the supervisory
authoritiesin their regulatory rolesand, in doingso, may receive
certain confidential information pursuant to thelawsof the relevant
jurisdictions.
- Thenewly-created FIO establishesa center of insuranceexpertise
within theU.S.federal government.
In carrying out certain of its functions,FIO will continueto interact
with insuranceand other regulatorsin the U.S.and theEU, and may
participatein exchangesof confidential information.
TheDodd-Frank Act requires the FSOC, the FIO, and the Office of
Financial Research (OFR), whichis an office within theU.S.
Department of theTreasurythat wasalsoestablishedby theDodd-
FrankAct, tomaintain theconfidentialityof any
data, information, and reportssubmittedunder that Federal law.

All FSOC membersenteredintoa MoU that setsout the
understandingof all FSOC membersregardingthetreatment of non-
public information.
TheMoU presumesthat non-public informationexchangedunder its
termsis confidential.
- Both regimesincludegeneral authorizationstoshare confidential
information with other financial regulators,law enforcement officials
and other governmental bodiesin need of such informationto
perform their duties.
Confidential information may onlybedisclosed to such personsif
theycan maintain confidentialityand/ or demonstrate their abilityto
protect such information from disclosurewhen the information is in
their possession.
Both regimesacknowledgethepossibilityof utilizingand disclosing
information in receivership and bankruptcyactions, prosecuting
regulatoryand criminal actions,and pursuant tocertain court
actions.
- Both regimesallowfor regulatorstoenter intoagreementsor MoUs
with counterparts in other jurisdictionstofacilitatethe sharingof
confidential information.
Both regimesprovide broad discretion toregulatorstoestablishthe
termsof such agreements,includingthe verification of each
regulator‘sabilityto maintain the confidentialityof information
receivedfrom another jurisdiction.
Both regimesaddressthe issueof potential sharing of information
with third parties, but achievesimilar outcomesin different ways.
EU Member State requirementsthat therecipient of confidential
information obtain explicit permission from theoriginatingsource
beforesharingwithanother regulator are often developed asa result

of legal constraintsunder theEU directives,while state insurance
regulatorsin the U.S. are bound by general legalrequirementsto
respect the confidentialityof informationunder the lawsof the
providingjurisdictionand thememorializationof this respect in
writtenconfidentialityagreements.
- Thesimilaritiesbetweenthe tworegimesare greater than anticipated
prior tothebeginningof this dialogue.
While there may be differencesin the form and application of
professional secrecyand confidentialitylawsbetweenthetwo
regimes,theyare substantiallysimilar in the subject matter
addressedand the outcome to be achieved.
It is acknowledgedon both sidesthat there is littleevidenceof
practical problemsrelatedtotheexchangeof confidential information
betweenstateinsuranceregulatorsin theU.S.and EU
regulators,althoughthe flowof information hasnot been substantial
sofar and may havebeen inhibitedby theinteractionof EU directive
constraintsand concerns over professional secrecy.
Topic 1:Policy objectives in relation to professional secrecy and
the exchange of information
Key Commonalities:
Neither regime includesa single, all-encompassingdefinitionof the
term ―confidential information.‖
Howeverboth regimesidentify general or specificcategoriesof
information that will be considered confidential by law and not subject
todisclosureexcept under specific definedcircumstances.
- Legal sources, asprimarily expressed through statutesand
directives,providethe foundation for the confidentialityof certain
categoriesof

information and thecircumstancesunder whichconfidential
information may be used and disclosed.
While statutes and directives provide the foundation, both regimes
recognize that confidentiality requirements may be complemented
through administrativeregulations,judicial opinionsand MoUs.
- Both regimesprovidea rangeof penaltiesthat may be leviedagainst
personswhobreach professional secrecyobligations.
Under both regimes, thepenaltiescan includelossof
employment, civil and administrativefines,imprisonment or a
combinationof thesepenalties.
Thedefinitionof thepenalties, aswellastheir enforcement, is
handled at the U.S.state or EU Member State level.
Key Differences:
- Thestructural approach toconfidentialityis very different.
TheEU approachstarts from thepresumption of confidentialityand
identifiesexceptions.
Within the U.S., theprovisionson professional secrecyvary from
stateto stateasthere is a cleareremphasis on accessto public
records.
Thepresumption in most casesis that informationis publicly
availableunlessit isdesignatedconfidential through statelawsor
statutes.
However, both regimestend towardthesame outcomesin terms of
protectinginformation identifiedasconfidential while facilitating
information exchangeamong supervisoryauthoritiesacross
jurisdictions.

Discussion/ Description of the Two Regimes:
The EU Approach:
TheSolvencyII Directiveprovisionson professional secrecyreflect
similar provisionsin the EU insurancedirectivescurrentlyin force.
Theseoperateon thebasisthat anyconfidential information receivedin
thecourseof the performanceitsdutiesby the supervisoryauthority
shall not be divulged to any person or authority whatsoever, except in
summaryor aggregateform, such that individual insurance and
reinsuranceundertakingscannot be identified.
There are limited exceptions to the general rule, covering cases covered
by criminal law and disclosure where a firm has been declared bankrupt
or is being compulsorilywoundup.
Theprofessional secrecyobligationcontinuesto applyafter employees
haveleft the supervisoryauthority, and the obligationalsoapplies
equallyto auditorsand expertsactingon behalf of thesupervisory
authority.
While there is nodefinition incorporated in either the existingEU
directivesor Solvency II of what constitutesconfidential information, the
interpretation of thescopeof theprofessional secrecyprovision hasbeen
wideranging.
It is generallytakento encompassall firm specific information received
bysupervisoryauthoritiesunlessit is alreadyin the public domain and
not just information that might be explicitlylabeledconfidential.
Supervisoryassessmentsof firmsundertaken by national supervisory
authoritiesare not disclosed, and thepublic availabilityof information
on theperformanceof insurersunder theexistingdirectiveswill vary
from EU MemberState toMember Statedependingon provisionsin
national legislation.

By contrast, the SolvencyII regime will incorporateprovisionsrequiringa
higher level of public disclosure of financial information acrossthe
EU, includingthe requirement on firms toreport annuallyon their
solvencyand financial condition.
Acommon professional secrecyprovision meansthat there isno legal
blockto the exchangeof confidential informationbetweennational
supervisoryauthoritieswithintheEU, and facilitatesthe participationin
EU colleges.
No further cooperationagreementsare required, but in practice colleges
oftendevelop their ownMoU toformalise the expected information
exchangein respect of theparticular group.
TheApproach in the State-based Regime in the U.S.:
Stateinsurancelawsincludemanyspecific referencesto the typesof
information that will be considered confidential, and notablystatelaws
generallyprovidethat examination workpapersand related
information, risk-based capital information and holding company act
filingsand examinationinformation are confidential.
Neverthelesstheextent of the availabilityof firm specific informationin
thepublic domain can help reinforcemarket discipline.
Theobligationof professional secrecyon the employees of state
supervisoryauthoritiesis applied through variousmeans.
Statelawsgenerallydeclarethat confidential information shall be
maintainedasconfidential, and confidential information shall not be
disclosedexcept asauthorisedby statelaw.
However, the professional secrecyobligationon theemployeesof
statesupervisorscan alsobe applied, or supplemented, by employment
law provisions,contractual obligationsor the internal rulesof thestate
supervisor.

Solvency ii News January 2013

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