The final part of an extensive interview Carlos Montalvo, Executive Director of EIOPA, in which he talks about the challenges of reporting, look-through and contemplates the future of Solvency II.
—Mr Montalvo is a proud Madrileño. When we chatted before the interview he seemed genuinely interested in my experience in the city and was keen both to hear where I had been and offer some recommendations. As I am no stranger to Madrid he proffered some suggestions off the beaten tourist tracks of Gran Via, Puerta del Sol and Prado: a selection of restaurants to the east of Retiro, and the Museo Lázaro Galdiano home of the 19th century collector, which my wife and I visited the following day. Four floors representing a lifetime of collecting things grouped in the simplest of taxonomies: coins, fabrics, gold statuettes of women holding baskets, etc. Mr Montalvo often refers to his Spanish heritage when speaking at events. In the three years following Solvency II I have heard quite a few stories and analogies about football and his beloved Real Madrid. Three years ago, at the first EIOPA conference he began a presentation with a slide of Goya’s Mujer Desnuda, a painting of a nude woman reclining on a sofa. His message: firms should stand naked in front of the regulator. Transparent.
Being transparentTransparency has become a cause celebre in the post-crisis regulatory environment; in Solvency II it is built into the DNA. But Pillar III (reporting and disclosure) has been treated as last and indeed least by many; the forgotten pillar, often addressed as an afterthought to the capital model and governance of the first two. Now the Long-Term Guarantees (LTG) measures have added another dimension to it as a new battlefront opens up over reporting the impact of the measures on the balance sheets. [caption id="attachment_138680" align="alignright" width="420"] Panel at the EIOPA Conference 2013
(L-R: Kay Blair, Pierre-Olivier Bouée, Carlos Montalvo, Klaus Wiedner)[/caption] The EIOPA LTG proposal called for the impact of the measures to be recorded separately as a “special” Own Funds item. This was later changed in the Omnibus II agreement to be incorporated in the calculation of the best estimate liability values, although firms are required to publicly disclose the impact of any measures they use. The industry is sending strong signals that it opposes any reporting of the impact of the measures separately. That tension surfaced in a somewhat edgy and highly entertaining exchange between Mr Montalvo and Pierre-Olivier Bouée, Group Chief Risk Officer, Prudential plc, at the last EIOPA conference. While discussing transparency Mr Bouée suggested there are “many ways to define it”. I asked Mr Montalvo how he defines transparency. “There is a good way to define transparency,” he says. “It is ensuring there are no relevant people – investors, analysts, supervisors – thinking that there is something hidden in the closet or under the cupboard. That is transparency.” He continues. “When you have nothing to hide you are being and you want to be transparent. Now why wouldn’t you want to be transparent? If you have a good story to tell, go on and tell it. The market will reward you for that. If you don’t have a good story to tell it’s a completely different story.” I can’t tell if he is talking in general terms or if he is being specific, and if so, when did he switch? But what is clear is that for him it is an open and shut case. Transparency is transparency – you can see what is inside and nothing is hidden. He maintains the same calm and directed manner. A sort of tranquillity with a purpose, which is not easily defined but rather sensed. Some combination of the razor sharp logic of a lawyer delivered with the tranquilidad of Madrid perhaps. If you didn’t see my notebook and faithful audio recorder you could have easily mistaken us for two guests in the hotel, enjoying a cup of coffee and the glow of the Madrid winter sun bursting through the glass walls of the café. Talk of transparency segues neatly, and naturally, to discussion on reporting of asset holdings and look-through, a topic that I have maintained all along is one of Solvency II’s as yet unrealised big stories, simmering quietly under the cover of delay and uncertainty – waiting to erupt. The look-through in Solvency II will require firms to identify, and account for, the underlying assets in collective investments. Like market-consistency, it has become one of those parts of the Directive that touches the very core of established conventions, albeit practical ones. What work has been done on look-through has laid bare the fact that what appeared to be a reasonable requirement (that insurers understand the full exposure of their investment portfolio) is turning out to be extremely challenging to deliver. To a large extend this is because of the technical difficulty in obtaining the data, which seems to have caught everybody by surprise. The industry makes a convincing case that at times this will require a large amount of effort and resources to obtain information that may be inconsequential to the firm’s exposure. You could credibly argue that a three per cent holding in a fund that is held by a fund of funds (itself representing less than one per cent of the insurer’s entire portfolio) is unlikely to have a material impact on the balance sheet if it defaults or loses half its value overnight. Still the fact that firms can’t easily identify their full exposure across the board has raised some questions. “When I was a local supervisor in Spain, in 2005 and 2006 I have seen some structured products owned by insurers and when you would scratch [the surface] you would get surprises. And companies didn’t know what was underlying because they didn’t do this look-through opening box type of exercise.” Look-through, according to Mr Montalvo, makes sense regardless of the Directive. “In terms of risk management leave aside Solvency II, leave aside regulation or supervision. Is that a sound exercise for companies to undertake? To try to understand what is underlying?” It’s a rhetorical question to which the answer “yes” hangs in the air. Propped up by the background chatter in the vast café. “One of the mantra questions out of the crisis in terms of lessons learned is: don’t buy something you don’t understand… Also don’t sell something you don’t understand.” “Do the look-through requirements help you understand what you’re buying or what you’re selling or not? And I think that depending on the response you’re giving, you have the response for the whole debate. If it helps you in your business in terms of understanding the assets that you’re acquiring or if you need that information, then forget about Solvency II. You should have had it indeed a number of years ago when perhaps you haven’t got into some problems or difficulties.” The whole debate is further complicated by the question of cost. Who should pay for providing this data, the insurer or the asset manager? Some argue it is an additional service, while others say it is a basic part of the service that should be provided. Mr Montalvo certainly has his view. “Now, the whole debate in terms of companies, asset managers and so on. I want a service, I want to understand what I am buying. If you don’t give me sufficient description of what I am buying, probably I would look for another provider or another product. But that should be embedded in the way that companies are run and managed. It shouldn’t be something that has to come from the regulator.” Like the debate on market consistency, the debate on look-through and transparency is gnawing at the essence of the workings of a part of the financial system. In trying to provide a safer risk-based approach to insurance regulation, Solvency II is uncovering what appear to be some deeply ingrained practices within the insurance industry and other parts of the financial system. Regardless of the final shape of the rules and the timeline these may prove some of the Directive’s more lasting legacies.