The European Commission is proposing a radical modernisation of prudential regulation of insurance and reinsurance companies across the European Union. It published a draft directive to this effect in July. Implementation of the ‘Solvency II’ project is planned for 2012. The objectives identified by the UK government include:
- deepening integration of the market;
- protecting policyholders and beneficiaries;
- improving the competitiveness of the industry in Europe; and
- promoting better regulation.
The proposed new rules and standards are considered more consistent with market practice and more risk sensitive than the existing rules, many of which date to the early 1970s. The intention is that the new regime should also be more fully harmonised across the EEA while giving appropriate scope for national insurance supervisors (such as the Financial Services Authority in the UK) to make day-to-day decisions and take into account the needs of their local markets. These objectives may not always be easy to reconcile.
The proposals recognise the increasingly international character of insurance by introducing a new regulatory regime for insurance groups. This will give credit for the benefits of diversification in the calculation of regulatory capital. International groups will have a ‘group supervisor’ with enhanced powers. This will usually be the supervisor for the jurisdiction where the group has its headquarters or main activities. It will have primary responsibility for, among other things, capital modelling across the group as a whole.
This newsletter discusses some legal issues within the Solvency II project and focuses on the proposed groups regime.
The legislative process
The directive proposed by the Commission contains the main outlines, or ‘level-one text’, of the proposed changes. The Commission hopes that the European Council and the European Parliament will be able to agree this text without major delays. The level-one text should be adopted by the middle of 2009 with a view to implementation in 2012.
The level-one text will be supplemented by further rules to be adopted by the Commission at level two and by non-binding guidance and standards to be developed by the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) at level three.
Some level-two rules may be adopted in further directives that member states will need to transpose into their own legal systems. The Commission may, however, adopt other level-two rules using Community regulations. Regulations are directly applicable in national law and do not, therefore, need further implementation by member states. They give the Commission more direct control over the outcome.
The proposed regime
The proposed Solvency II regime adopts in general outline the approach to prudential regulation applied in the banking sector under the Basel Capital Accord. The three pillars within Basel are:
- Pillar I regulatory capital requirements;
- Pillar II supervisory review; and
- Pillar III public disclosure and market discipline.
Under Pillar I, new market-consistent rules on calculating technical provisions are being developed using the cost of capital approach for non-hedgeable risks. This approach uses the spread above the risk-free interest rate that a BBB-rated insurance or reinsurance undertaking would be charged to raise eligible own funds. There are to be two levels of regulatory capital, the Minimum Capital Requirement (MCR) and the more risk sensitive and higher Solvency Capital Requirement (SCR). A breach of the MCR will give rise to the most serious regulatory consequences (such as a revocation of the insurer’s authorisation to take on new business). The formula for calculating it has yet, however, to be agreed. Insurers and insurance groups will calculate the SCR in accordance with a standard formula, or, with the approval of the relevant supervisor, using their own internal models.
Under Pillar II, if the supervisor is not satisfied that the SCR provides for all relevant risks it may supplement it with an ‘add-on’. The sum of the SCR and the add-on is referred to as the ‘adjusted SCR’. It is intended that the amount of the adjusted SCR, but not the detail of its calculation, should be publicly reported under Pillar III.
Other aspects of Pillar II and Pillar III reporting will eventually be brought more closely into line with international accounting standards.
The current regime
Until 2001 the European directives provided for supervision of insurance companies on a solo basis only. The ‘supplementary supervision’ regime brought in by the Insurance Groups Directive provided for insurance companies carrying on direct insurance business to be supervised by reference to the insurance group of which they are a member. They are also supervised by reference to their holdings in other insurance and reinsurance companies (which we refer to collectively as ‘insurers’). In 2005 supplementary supervision was extended to apply to certain financial conglomerates. The conglomerates in question are those whose activities meet certain minimum thresholds within the insurance sector, on the one hand, and the banking/investment sectors on the other hand.
The regime is due to be extended again from the end of this year, when the Reinsurance Directive is due to be implemented. It will then apply directly to ‘pure reinsurers’.
The group proposal
Title III of the level-one Solvency II Directive takes things a step further. Following suggestions originating in the UK, it proposes a significant shift in emphasis in prudential regulation from the solo to the group level. This will be achieved by a new group supervision regime.
The new regime will allow certain groups to maintain the SCR at group level, but not necessarily at the level of each solo member of the group. Application of the group regime will be subject to compliance with a number of conditions and the approval of the group supervisor.
Groups that choose not to apply (or cannot meet the requirements) for treatment under this regime will continue to be subject to supplementary supervision. Internal models approved by the group supervisor may, among other things, factor in the benefits of diversification across the group if the supervisor is satisfied that there is adequate evidence of those benefits. Each solo insurer within a financial group will be required in any event to maintain its MCR even when the new group regime applies.
Benefits of the new regime
The main apparent benefits of the new regime for groups will be:
- that insurers within the group will not be required to maintain the SCR at solo level provided that there is adequate capital across the group as a whole;
- the scope for taking credit for diversification benefits across the group to reduce regulatory capital;
- the advantage of working mainly with the group supervisor in approving capital modelling; and thus
- being protected to some degree from the full burden of complying with multiple prudential regimes.
Some questions for consideration
It is too early, however, to determine whether the new group regime will provide concrete advantages in practice because there are a number of issues still remaining to be settled. These cover:
- how the MCR is to be calculated. The UK preference is for a ‘compact’ approach under which the MCR would be a defined proportion of the SCR. However, the alternative ‘modular’ approach is preferred by some member states and smaller insurers. The modular approach uses a formula different from that used for the SCR. It might produce a result that is close to or even above the SCR. Such an outcome would undermine the main advantage of the proposed group regime;
- the requirement that groups provide a declaration of group support. The purpose of such a declaration would be that, in the event of the insolvency of any insurer member of the group, capital would be injected by the group into the member to pay off its policyholders. Such a requirement, however, raises issues about the transferability of capital across the group and the compatibility of such declarations with national company law, insolvency law and compensation schemes;
- how the benefits of diversification are to be identified and quantified;
- how the new regime will apply to groups with significant operations in jurisdictions outside Europe, many of whose regulatory regimes may not be considered equivalent to Solvency II;
- whether holding companies, at the top of or within a financial group, which often do not themselves carry on regulated activities, should be subject to direct supervision; and
- the extent to which the solo supervisor of an insurer within a multinational group may be able to apply capital or other requirements to that insurer (particularly when its financial condition is weakening) in a way that may undermine the benefits of the group regime.
The answers to these questions will doubtless emerge gradually over the years leading to the 2012 implementation deadline. As the picture becomes clearer it may become possible to make a full cost benefit analysis of the new group regime and to focus more closely on developing the necessary systems for taking advantage of it.
A robust and effective regulatory framework
Hitherto the emphasis within the Solvency II project has been on the policy outcomes to be achieved. The success of the project may, however, depend to some degree on achieving a robust and effective regulatory framework. In this newsletter we mention a few of the issues.
Article 27 says that the main objective of supervision is policyholder protection. The regulatory objectives of the Financial Services Authority (FSA) under the Financial Services and Markets Act 2000 are, by contrast, much more balanced. Moreover the FSA’s experience suggests that regulatory objectives do significantly (and appropriately) influence supervisory policy. So there may be a case for expanding on article 27.
There are other references to the protection of policyholders in the directive (eg article 129(2)). It might be argued that the result is to give policyholders enforceable rights where directive requirements are not complied with. If that were the case it might encourage a ‘defensive’ approach to supervision, which would perhaps be unfortunate.
Loose ends, for example run-off
There is much work to be done on improving the text of the directive to ensure that all significant policy objectives are adequately covered. For instance, the draft text seems to leave insurers in run-off outside its scope because the text is structured around premium income and run-off firms may not have any. This may not have been the intention. Run-off firms might be brought within the directive by reference to thresholds based on their technical provisions.
Level of detail
The FSA is reducing the length of its rulebook to achieve more ‘principles-based regulation’. This gives wider scope over how insurers can achieve the outcomes desired by the regulator. It also eliminates a great deal of needless detail that may create compliance burdens without corresponding benefits.
In the explanatory memorandum to the directive, the Commission says that ‘the new solvency provisions are principles-based’. This is certainly true of much of the proposal. The position is different, however, for the material that is brought forward word for word from the current regime (‘the acquis communautaire’). Much of this is over 30 years old and overdue for reform. The first stage could be for the acquis to be reduced to basic principles so that it can be more flexibly developed and updated at levels two and three.
There is also arguably an excessive level of detail in the new regime in Title III for insurance groups. Experience over the seven years since the first insurance group supervision regime came into force has shown that major changes have tended to be made either at national or at European level almost on an annual basis. Much of the detail in title III may therefore constrain future development. It could usefully be demoted to level two, where it may be amended without the need for a further level-one directive.
By contrast there are other parts of the level-one directive where detail may be inadequate. An example is the formula for calculation of the MCR in article 12. This is still controversial and should therefore probably be agreed at level one.
The existing European insurance and reinsurance directives in general apply minimum standards. Member states can and often do ‘gold plate’ these standards. The prudential regime introduced by the FSA at the end of 2004 went well beyond the current directive standards. To a large degree it anticipated the ideas behind the Solvency II project. Gold plating has sometimes led to regulatory arbitrage eg insurers choosing their home state on the basis of how onerous the local prudential regime may be.
The Commission has indicated that much of the Solvency II directive is intended to achieve maximum harmonisation. This applies particularly to Pillar I matters such as technical provisions, the SCR and the MCR. The maximum harmonisation principle has not, however, been articulated in the directive and it is not clear to what extent it applies in the supervisory review process under Pillar II. This is significant because supervisors exercise a wide degree of discretion.
For instance, article 37 of the directive allows add-ons to the SCR to be applied in ‘exceptional circumstances’. Yet the FSA’s recent publication ICAS – lessons learned and looking ahead to Solvency II makes it clear that the FSA applies these add-ons (‘capital guidance’ in its own terminology) systematically and intends to continue to do so.
In other respects the directive expresses a rule in highlevel and absolute terms when this may be too simplistic. This is the approach, for instance, to the requirement for an insurer to have a risk management function (article 43). There is no guidance on how this would apply in proportional terms to smaller firms. By contrast the description of supervisory powers and duties in article 34 makes it clear that they should be applied ‘in a timely and proportionate manner’.
There is much work still to be done in developing the Solvency II regulatory framework. Part of this process will be to draw on lessons learned from the development of the FSA’s new prudential regime in 2004 and the implementation of the Markets in Financial Instruments Directive and the Capital Requirements Directive. Freshfields will be reporting regularly on the project as it progresses.