Background
Consultation Paper 58/09 (CP58) sets out CEIOPS' draft technical advice to the European Commission for the development of the level 2 implementing measures of Pillar 3 of the Solvency II regime. Pillar 3 deals with the requirements for supervisory reporting and public disclosure under the Solvency II regime. The objectives are to harmonise reporting, promote comparability of valuation and reporting rules with International Accounting Standards, introduce proportionate requirements for small undertakings and ensure efficient supervision of insurance groups and financial conglomerates.
CEIOPS has considered a number of options in its impact assessment on the most appropriate content, frequency, level of assurance and format of the reporting.
The reporting requirement applies at both a stand alone regulated entity (so called "solo" reporting level) and group level. At both levels insurers need to set out in a disclosure policy, approved by management, appropriate governance procedures to ensure timely, complete, consistent and accurate reporting.
The key reporting requirements are:
1. Solvency and Financial Condition Report (SFCR)
This report is the public disclosure which is expected to be made available via electronic publication. The SFCR will be required within either 3 or 4 months of an insurer's financial year end. The SFCR must follow a prescribed structure that CEIOPS developed based on the Framework Directive. The areas covered in the SFCR are: Business and Performance, System of Governance, Risk Management, Regulatory Balance Sheet and Capital Management.
2. Report to Supervisor (RTS)
The RTS is not public and is communicated only to the firm's supervisor. The RTS expands on the SFCR's disclosures using a similar, prescribed structure but this time presenting the information differently as part of the ongoing supervisory dialogue with the firm. For example the summary of business and risk strategies and the financial and non-financial objectives associated with them, the explanation of variance to plan rather than the prior period, and expected future developments are areas where the SFCR would be silent. The frequency with which an undertaking has to provide full qualitative information through the RTS will be linked to the intensity of the Supervisory Review Process (SRP). CP58 indicates that each regulator must require the RTS every five years, at a minimum. However the frequency could be increased up to an annual basis.
3. Private reports to the regulator on occurrence of pre-defined business events (for example changes in business strategy)
Content of the new reports
The content required builds on existing IFRS disclosure, as the reference framework for the regime, incorporating Solvency II specific outputs such as the internal model and details of the Own Risk and Solvency Assessment (ORSA), and defines materiality in the context of the IAS definition.
Both the SFCR and RTS contain qualitative and quantitative information including prescribed Quantitative Reporting Templates (QRTs). CP58 sets out several provisional QRTs of which a subset will be reported to the supervisor on a quarterly basis, 3 or 4 weeks after the quarter end. CEIOPS will be providing full guidance, definitions and requirements as it develops the Level 3 guidance for European supervisors.
CP58 confirms there will be some form of external audit requirement and sets out tentative conclusions, to be finalised at Level 3, on which quantitative and qualitative aspects of the new reporting regime could be included in the scope of the audit.
CP58 specifies the structure for the SFCR and RTS, proposing the minimum content of the information required to make it easier for supervisors and users of the public disclosure to compare one insurer with another and achieve the objective of improving market transparency.
Appendix 1 gives a summary of the structure for the SFCR and RTS and details the key additional information required in the RTS but not in the SFCR. In broad terms the RTS requires information relating to the following example areas which are not required in the SFCR:
- the business and risk strategies including the business continuity plan;
- legal and regulatory issues affecting the business;
- variance against plan rather than prior period;
- future anticipated solvency needs, underwriting performance projections and changes in risk exposure; and
- significant additional disclosure explaining the results of the internal model.
As explained above the SFCR and RTS are required for each regulated entity and at group level. However CP58 also sets out the proposal for a single group-wide SFCR where each solo SFCR, for the parent and subsidiary entities, is included in an annex. It may also require each annex to be translated into a language commonly understood by all the other supervisory authorities concerned.
CP58 does not include proposals on when the first SFCR and RTS will be required: whether it is intended to be the first financial year end after Solvency II comes into force on 31 October 2012 or after that date.
A summary of the requirements is set out in Appendix 2.
Key themes
We have identified a number of key themes in common with the rest of the Solvency II regime which are of particular importance for Pillar 3:
- Alignment with IFRS;
- Need for senior management engagement; and
- Control, documentation and assurance.
Alignment with IFRS
To minimise the administrative burden of Pillar 3 the Solvency II reporting extensively refers to IFRS disclosures. This approach is consistent with the reference to IFRS as endorsed in the EU as the basis for valuation of assets and non-insurance liabilities in the solvency balance sheet as proposed in CEIOPS CP35 published last March.
CEIOPS seems to have contemplated market-wide synergies that would arise from using IFRS as the single statutory reporting basis across the EU. However the draft regulations do not go as far as making IFRS the required financial reporting framework, leaving it to member state governments to extend voluntarily the use of IFRS beyond listed companies.
This is a decision which is likely to be taken in the UK effective for accounting periods beginning on or after 1 January 2012. A paper is expected to be published by the UK Accounting Standards Board in early August 2009 seeking views on its proposal to replace current UK GAAP by adopting IFRS for Small and Medium-sized Entities. If this is the case then all UK insurers will have IFRS as their financial reporting framework by the time Solvency II is implemented.
European insurers are currently at different stages in relation to the adoption of IFRS – as shown in the table below for a sample of UK insurance companies.
Although IFRS and regulatory reporting serve different purposes, the latter is being developed with the objective of alignment with IFRS. Both frameworks recognise risks and their management as key disclosure requirements. In particular, the ability to see how risk and capital are managed by senior executives will provide valuable insights into the quality of risk management and decision making to European policyholders.
The extent of the similarities of a UK insurer's current financial reporting with the future solvency reporting requirements depends on whether it already complies with IFRS, in particular with IFRS 4 and IFRS 7, or their UK GAAP equivalents, the Operating and Financial Review (OFR) and the Combined Code on Corporate Governance. In Appendix 3, we can see the considerable overlaps between the disclosure requirements of Pillar 3 and current financial reporting requirements, including IFRS, Companies Act 2006 and the UK Listing Rules.
For insurers already on IFRS the key issue ahead of developing Pillar 3 implementation plans is to establish how good the IFRS disclosures are compared with the requirements of the SFCR. The use of existing public disclosures is subject to a qualitative test of equivalence in terms of their nature and scope (article 52 of the Framework Directive).
The finalisation of the IFRS 4 Phase II project will provide further alignment between Solvency II and IFRS. For example, both Solvency II and Phase II use best estimate valuation techniques as the starting point for the measurement of the insurance liabilities. However Solvency II will not follow the IFRS product classification but instead define its scope based on the legal entity regulatory status as an authorised insurer selling regulated products which could include both insurance contracts accounted for under IFRS 4 and investment contracts accounting for under IAS 39. For jurisdictions such as the UK where tax for life insurers is based on regulatory returns this difference in scope could also have tax implications.
The alignment of Solvency II to IFRS offers an opportunity for insurance companies to adopt an integrated approach that, with the implementation of IFRS at legal entity level, would facilitate the compliance with the Solvency II requirements and simplify processes and systems of the organisation. We believe that simplification of reporting processes could be achieved if the insurer starts from an IFRS basis to build its Solvency II reports.
Senior management engagement
The type of information which needs to be disclosed under Pillar 3 will mean that senior management need to engage in the preparation as well as review of the SFCR and RTS. Some of the statements to be disclosed will not be easily delegated to the financial reporting function, for example around business strategy, ORSA and system of governance. The relative ease with which users will be able to interrogate the disclosure given its comparability will further increase pressure on Boards to "get it right".
Since the main stakeholders addressed in the SFCR are the policyholders – the paper even states the executive summary should be aimed specifically at them – the SFCR could be a great vehicle to enhance the relationship between insurers and their customers. It is possible that customer relationship directors would be directly involved in shaping the SFCR which could become an element in the customer retention strategy if the messages of strong capital position and effective risk management contribute to reassure policyholders that their money has been safely placed with the insurer. These considerations, combined with the sheer range of information required, will have a profound impact on the internal organisation of insurers. For example we believe it will stimulate the change in the communication and interaction between finance and other functions such as risk management, compliance and the actuarial function that would call for a far more integrated approach to financial and regulatory reporting than under the old operating model.
This is not simply a Pillar 3 observation but one that applies throughout Solvency II. For example, the requirement for the ORSA to be embedded in the day to day decision making of the insurer will require internal MI to spell out clearly the risk and capital impacts of different course of actions and business decisions. The need for this alignment arises from the consideration that to deliver external reporting that is relevant, reliable and comprehensible then communication must be relevant, reliable and comprehensible internally. Those responsible for preparing the new reports must be encouraged and empowered to challenge the technical input from other departments. Senior management must take the lead to make this new reporting process work effectively and collaboratively.
The chart opposite maps the range of information required in the proposed SFCR against the different departments most likely to be responsible for preparing and reviewing across the three lines of defence. Clear communication between these moving parts is vital to ensure a consistent, complete and accurate message is conveyed externally and to the supervisors.
Control, documentation and assurance
Disclosure policy
Insurers need to develop a written policy detailing:
- the governance procedures;
- responsibilities;
- timeframes;
- materiality principles;
- identification of information already considered in the public domain and process to validate that it would be of the same nature and scope of the required disclosures; and
- the process for the identification of information for which to seek regulatory permission of non-public disclosure on the confidentiality grounds set out under article 52 of the Framework Directive.
Whilst insurers may well have timetables with the key milestones and deliverables for regulatory reporting in existence at the moment, they are less likely to have a documented policy supported by robust processes and controls. In developing this written policy and the related infrastructure, the insurer should consider how to have its departments interacting with each other to avoid inefficiencies and duplication of effort and at the same time ensure consistent, accurate and complete compliance with the policy and the regulations.
Asset management certification
One further aspect which senior management needs to consider is the requirement in the SFCR to certify that assets have been invested in accordance with the "prudent person" principle, namely that the complexity of the assets underlying the insurer's portfolio is commensurate with the ability of the appropriate personnel and systems to understand, monitor and manage those instruments. The introduction of this certification process is not unique to Solvency II. For example the UK government has recently introduced a requirement of "certification" for the accurateness of tax returns.
External audit
As noted previously the paper confirms there will be some form of external audit requirement and sets out tentative conclusions on which aspects this will include as set out in Appendix 4.
We do not consider that the scope proposed for external audit is unduly onerous and recognise there will be synergies with the existing statutory audits of financial statements. However, this form of audit would be an additional compliance cost that the regime could introduce.
CEIOPS recognises the difficulties for requiring an external audit of an approved internal model and has not included this in the proposed scope. Requiring the audit of internal models that do not generate audited financial information would call for an extensive audit effort with significant cost implications for the sign off to be achieved within the timelines envisaged. On the other hand the internal model is the corner stone of the new regime and the regulators need to be satisfied that there are alternative forms of external oversight to give assurance to the market that the internal model is used as approved.
Another fundamental dimension of the decision on audit requirements is the legacy of each member state. The UK market is used to regulatory returns being subject to audit. Indeed, following the reviews into the actuarial profession after the closure to new business of Equitable Life, the scope of external assurance on UK regulatory returns increased with additional responsibilities for the Independent Auditor and a new role of Reviewing Actuary. This approach is not common among other member states where there is limited external audit involvement as the table below demonstrates.
Pillar 3 implementation programme for 2009 and beyond
The timing of a Pillar 3 programme will be significantly influenced by the finalisation of the proposals of the Level 2 implementing measures that the European Commissions expects to adopt formally by November 2010 and the outcome of other Solvency II legislative projects, for example the development of Level 2 implementing measures for the ORSA and the SCR, as well as by the size, nature and complexity of the insurer.
CP58 encourages insurers to start analysing the potential disclosure requirements now and begin assessing changes that could be required to IT systems if these proposals were finalised as drafted. CP58 obviously also discourages any full system implementation activity at this stage. Significant CEIOPS work has already been inputted to develop the QRTs and, as it points out, much of the information will be information which management itself needs to monitor the business compliance with Solvency II.
Interpreting the disclosure requirements as if they were final, developing a strategy for disclosure and educating key internal stakeholders on the potential impact impacts are all sensible steps that insurers could begin right now, with the added benefit of providing senior management with the detailed knowledge that would make their comments to CP58 focussed and tied to specific business issues (comments to CEIOPS are due by 11 September 2009).
We envisage a Pillar 3 programme could have three main components:
- disclosure impact assessment – to identify the impact of the proposed requirements on existing reporting procedures (systems, data, people, processes and controls);
- disclosure design – to design the structure and principles of the Solvency II reporting regime; and
- disclosure report building and implementation – to implement changes to the reporting framework to deliver the Solvency II requirements.
Insurers clearly need to ensure they meet the minimum level of regulatory compliance in their Pillar 3 reporting when Solvency II is operational on 31 October 2012.
However by investing in a reporting programme we believe insurers can optimise the use of their Solvency II resources and turn the compliance burden into a number of strategic opportunities:
- Building a trusting relationship with customers, shareholders, rating agencies and other stakeholders. A number of recent examples have highlighted the damage and loss of trust inaccurate reporting can cause. We believe that relevant and accurate disclosure of risk and capital management can improve reputation and confidence;
- Aligning Solvency II with IFRS information could help investor relations. Delivering both quantitative and qualitative risk information to investors would help support efficient markets and would help reward management strategy by demonstrating how the risk appetite is linked to strategic objectives and decisions and to the IFRS profit;
- Building a brand that is recognised for strength of capital position, transparency in its operations and sound risk management practices to maintain customer confidence and hence market share; and
- Demonstrating the effectiveness of control functions such as risk, compliance and internal audit, giving greater assurance over the reporting, particularly if the ultimate choice on the external audit requirements is for a limited degree of independent assurance.
Conclusion
We concur with CEIOPS in highlighting the importance of analysing the implications of Pillar 3 requirements to leverage as far as possible existing reporting processes, systems and controls and to take advantage of the strategic opportunities Pillar 3 offers.
IFRS, as endorsed in the EU, has emerged as the usual reference framework for the Solvency II balance sheet and disclosure. There is an opportunity for insurers to adopt an integrated approach to move beyond short term IFRS conversion measures by implementing IFRS and Solvency II systems and processes concurrently, particularly following the plans of the International of its projects on insurance liabilities and investment accounting in the next 24 months.
A Pillar 3 programme starting with an assessment against the proposals of CP58 should help insurers prepare for the production of useful, transparent and tailored information, consistent with other disclosures that can help to capture these advantages.
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