Introduction

This briefing looks at Solvency II from the perspective of in-house lawyers. It explains the basic structure and terminology used in Solvency II and suggests areas where it is likely to have an impact on the work of an in-house lawyer.

Solvency II and the in-house lawyer

The Solvency II Directive is due to be implemented by 31st October 2012 and with three years until implementation it may be very tempting to put getting up to speed with the Directive on the back burner. Nevertheless, by this time next year many of the outstanding detailed issues should have been resolved. Indeed, a great deal of the detail is already available and the volume of information to take in might be daunting if you have to do so all at once.

It therefore seems worthwhile trying to keep up with Solvency II developments, at least in high level terms. This may not be as difficult as it seems. The effect of Solvency II will, in a number of important areas, be to replace detailed FSA rules with formulae built into models (either the standard one or a insurer’s own) for which lawyers will thankfully not be responsible!

This note seeks to set out those areas where lawyers may be expected to be involved in the Solvency II process.

Before doing that it is worth reminding ourselves of the basics of Solvency II:

  • The new solvency regime will be risk-based and is an evolution of the FSA’s current regime.
  • Insurers will be required to satisfy a Minimum Capital Requirement (MCR) and to run the business in such a way as to satisfy a higher risk-based capital requirement, the Solvency Capital Requirement (SCR). Breach of the MCR will trigger an automatic loss of the insurer’s licence, whereas breach of the SCR will be likely to trigger regulatory intervention.
  • The SCR will be calculated using either a standard formula or a bespoke “internal” model or, in some circumstances, a partial internal model together with the other components of the standard formula. The risks to be covered by “modules” of the model include underwriting risk, market risk, credit risk and operational risk. Internal models will need to be “used” to manage the business and approved by the relevant supervisor. However, they will not be subject to a separate external audit.
  • Groups also need to calculate a group solvency capital requirement. This can produce a lower group requirement than the aggregate of the individual members’ own requirements. Individual members of the group will still have to comply with their own “solo” requirements but surplus arising only at the group level (ie because of a lower group capital requirement) may be treated as additional capital. There are, however, also capital instruments (eg hybrid capital and subordinated liabilities) which will count for the solo SCR but not the group SCR.
  • Insurers will be subject to requirements to have adequate governance arrangements in place, including risk management, actuarial and compliance functions. The risk management function is to be responsible for the design, implementation and validation of any internal model.
  • In addition, insurers will have to produce an “Own Risk and Solvency Assessment” (ORSA). This is the insurer’s own assessment of its solvency position and may reflect areas where, for example, the standard formula is not appropriate for the insurer. It is different to the current ICA in that most of the risk-based assessment of capital should be built into the SCR calculation.
  • Supervisors have the right to require “capital add-ons”, which after a potential five year initial transitional period, will be made public. However this right is limited to areas where the risk profile is not in line with that in the SCR or there are “significant governance deficiencies”. The right is also supposed to be used only in “exceptional circumstances”.
  • One of the fundamental changes in Solvency II is the move to a market consistent valuation of liabilities (on the basis that your capital will never be set properly if you do not have a realistic view of your liabilities). This means that unless you can find a hedge for your liabilities you value them based on expected future cash flows discounted appropriately, and hold a "risk margin" to reflect the cost of capital that would be required to transfer the liabilities to a third party.
  • The Directive also includes rules on how insurers’ capital requirements can be satisfied. Capital held known as “Own Funds” is either Basic Own Funds (what a insurer has on the balance sheet, eg the excess of assets over liabilities plus subordinated liabilities) or Ancillary Own Funds (what a insurer may be able to call on if needed, eg unpaid capital, letters of credit, guarantees and other legally binding commitments). Ancillary Own Funds can only be used with the approval of the supervisor. In addition, Own Funds are divided into three tiers to reflect their permanence and ability to absorb losses.
  • Although the Directive does not contain the Group Support provisions that would have enabled the SCR to be held at group level (with just the MCR held at individual insurer level), it contains provisions that mean this decision will have to be reviewed three years after implementation.
  • The Directive also includes provisions for more detailed public disclosure of an insurer’s management of its business and capital in the form of a “Solvency and Financial Condition Report” (SFCR).

Where are we now?

The terms of the Directive, which was adopted in April 2009, provide for CEIOPS (the Committee of European Insurance and Occupational Pensions Supervisors) to provide additional detail and guidance in relation to the extent and effect of the Directive’s requirements. CEIOPS has completed two consultation periods already and has just (on 2nd November 2009) issued a third set of consultation papers.

The first two sets of consultation papers have been useful to bring out the proposed detail of the new regime but have also been criticised in places for being more restrictive than the Directive (eg in relation to the limits for the relevant tiers of capital). It will be interesting to see what the third set contains.

Differences to the current UK regime

Capital instruments and assets

The rules providing how capital instruments will be classified under Solvency II are different to the current FSA Rules. Own Funds will be divided into three tiers to reflect their permanence and ability to absorb losses. So, for example, there will be minimum duration requirements in relation to each “Tier” of capital. Broadly Tier 1 must have a minimum term of ten years, Tier 2 of five years and Tier 3 of three years. This is however subject to the very important caveat of the “sufficient duration principle” which means that the term must reflect the insurer’s underlying liabilities. CEIOPS has suggested that for Tier 1 this means until the date of the insurer’s latest liability, and for Tier 2 the average period of the liabilities. Also, Tier 1 instruments must rank pari passu to absorb losses on a going concern or winding-up basis. As a result, instruments which are currently Tier 1 instruments under the FSA rules may become Tier 2 instruments under Solvency II.

Although the vast majority of reserves (ie representing the excess of assets over liabilities) will be categorised as Tier 1 Basic Own Funds, some assets will not be able to count as Tier 1 (eg where their use is restricted or they cannot be freely realised). Also, where instruments become “Ancillary Own Funds” under Solvency II, regulatory approval will be required for their use.

There are currently no grandfathering or transitional arrangements for capital instruments that comply with the current requirements but which do not comply with the Solvency II requirements (eg hybrid debt instruments). This could involve a lot of work for lawyers in either replacing or amending any such instruments. Solvency II also contains requirements similar to the current FSA rules in relation to repayment of the instrument needing the consent of the regulator, requiring a contractual lock-in of the instrument on a breach of the SCR, preventing encumbrances in connection with such an instrument and providing that the instrument cannot cause or accelerate the insurer’s insolvency. There may also be requirements to get legal opinions in relation to the enforceability of certain instruments.

Treatment of Reinsurance and ISPVs

Reinsurance is treated differently under Solvency II and additional requirements will apply in relation to risk mitigation techniques. This may have an impact in particular on the internal reassurance and other arrangements where, for example, the reinsurer is outside the EEA and is not rated (a minimum rating of BBB has been suggested by CEIOPS). From a lawyer’s perspective there will also be increased emphasis on risk transfer and the terms and enforceability of agreements passing insurance risk. The guidance in relation to risk transfer set out in the relevant CEIOPS paper mirrors the current FSA INSPRU guidance. It stresses that, although the economic effect takes precedence over legal form, there needs to be legal certainty in relation to the effectiveness and enforceability of the relevant arrangement. This could involve getting legal opinions from other jurisdictions.

In addition, the Solvency II regime for Special Purpose Vehicles is likely to be different to the current UK ISPV regime. It seems that there will need to be a fixed limit on the SPV’s liability (rather than, as at present, one that is linked to the value of the assets held) and the cedant may need to retain at least 5 per cent of the risk. However the Directive does provide that existing ISPVs can continue post Solvency II but it is not clear what the effect on the cedant's capital position will be.

Investment and other requirements

The current rules on admissible assets (ie a list of qualifying asset types) will be replaced by the "Prudent Person Principle" (ie the requirement to invest so as to ensure the security, quality, liquidity and profitability of the portfolio as a whole) with the requirement that assets covering technical provisions must be invested in “the best interests” of policyholders. It is not really clear what investment in the best interests of policyholders means but it could cause issues for intra group investments or where there are potential group conflicts. The Prudent Person Principle effectively places responsibility on the insurer to decide whether the nature of any investment is appropriate and an obligation to show that it has appropriate systems and controls to hold and manage any such investments. In practice this may require insurers to give their investment managers more detail about the type of investments permitted. There is also a suggestion from CEIOPS that an additional operational risk charge will apply to the largest amount held by an external fund manager.

Similarly, the formal counterparty and asset limits currently in INSPRU 2.1.22 will disappear as counterparty default risk, market risk, credit and concentration risk will be built into the calculation of the SCR. Calculation of the market risk will involve a “look through” to underlying investments of derivatives and collective investment schemes which, unlike the current counterparty rules, will also extend to UCITS, although UCITS will benefit from a specified formula to simplify the calculation.

Insurers will still, as part of their own governance requirements, be expected to adopt their own limits on counterparty and group exposures and it will be interesting to see how these compare to the existing maximum regulatory limits.

Governance

It is hoped that UK insurers with documented risk and other policies will be relatively well placed in relation to the Solvency II governance requirements. However the new requirements for non-life companies to appoint an actuary who expresses an opinion on the overall underwriting policy and to formalise the compliance and risk management functions, could lead to internal reorganisations; as could the requirement that the risk management function should effectively own any internal model. There is also a requirement in the Solvency and Financial Condition Reports (SFCR) (see further below) to certify that assets have been invested in accordance with the Prudent Person Principle. Insurers are likely to have to undertake additional work to substantiate the level of controls they have on their investment managers.

Another area where additional effort may be required to formalise existing practice is in relation to management actions, particularly for life companies where the proposed action (eg to sell equities) could have an impact on the amount of technical provisions or mitigate the effect of some stressed scenarios - at least going forward. The CEIOPS guidance (in CP32) says management actions must be “objective, realistic and verifiable”. It seems clear that supervisors are intended to scrutinise management actions more closely in the future. This could mean that lawyers may also be asked to review and help formalise them.

Remuneration is also an area where there should be changes under Solvency II. The FSA’s recently introduced regime in relation to remuneration does not currently apply to insurers. Under Solvency II the fixed component of remuneration should be “sufficiently high enough to allow a fully flexible bonus policy” and payment of the major part of the bonus should contain a deferred component which reflects the “nature and time horizon of the business”. Any bonus should also be made up of both individual and collective performance objectives.

Groups

The main changes for groups should be that because of the move to a “consolidation” approach calculation, the group risk based solvency requirement has the potential to benefit from diversification, particularly if the internal model is also used to calculate the group SCR. The group calculation will also include the effect of any ancillary service undertakings in the group which are currently valued at zero. For example, if an anciliary service company were to have a negative net worth, this would reduce the group capital, whereas currently it would have no effect. It is also to be hoped that a more co-ordinated approach to supervision will reduce the scope for regulatory inconsistency.

Public Disclosure and Audit

Under Solvency II insurers will be required to produce an annual SFCR which, in addition to setting out its financial position, provides details of its business, its internal controls and its risk management. The SFCR has to contain a summary written for the benefit of policyholders and in terms that they can understand. In addition the insurer will have to make a Report to its Supervisor (RTS).

In CP58 CEIOPS has set out its view of financial items likely to require external audit. The UK already has an external audit requirement for regulatory firms so this will not be as big a change as in other countries.

Unit-Linked and Non-Profit Life Business

There will be changes to the financial position for unit-linked and non-profit life business due to the move to a more realistic market based valuation of liabilities. It is anticipated that this could take out some of the margins currently included in the current reserves for such products. It seems there may also continue to be separate investment rules (ie not the Prudent Person Principle) for unit-linked contracts provided that the policyholder is a natural person who bears the investment risk and the rules are not more restrictive than those for UCITS. This could be a significant change as the current UK permitted links rules are more restrictive than the UCITS rules, particularly in relation to the use of derivatives. It may also mean that such contracts could be sold to corporate bodies subject only to the Prudent Person Principle on investment, which would be a significant derogation in the UK from the permitted links rules.

Where is the in house lawyer likely to become involved?

  • Reviewing, amending or replacing existing capital instruments
  • Approaching the Regulator for approval of Ancillary Own Funds
  • Review reinsurance arrangements to ensure risk transfer and enforceability
  • Setting up new SPV arrangements or unwinding existing ISPV arrangements
  • Reviewing formalised management actions
  • Reviewing and amending existing investment management agreements and mandates to ensure compliance with the Prudent Person Principle, taking out references to admissibility and other rules (eg counterparty and asset)
  • Reviewing any new permitted links rules
  • Reviewing policyholder summary in SFCR and other public disclosures
  • Reviewing outsourcing contracts - as third party suppliers must now speak directly to the FSA and there will be no grandfathering provisions for existing agreements
  • Reviewing protection for directors (who need to understand model)
  • Reviewing Remuneration policies, contracts of employment and incentive schemes