Recent developments in issues affecting non-European firms and groups under Solvency II
How should third country insurance and reinsurance operations be treated in the European regulatory structure? This is one of the controversies still being debated in negotiations aimed at agreeing the final form of the Solvency II regime. In this issue of Insurance and reinsurance news we give an update on this question and discuss how it may ultimately be resolved.
Current deadlock on Solvency II
The Solvency II project is aimed at producing a comprehensive and risk-sensitive regime for the prudential regulation of insurance in Europe. Key aspects of the proposed regime have proven intensely controversial, so it is unlikely that it will come into force until 2016 or later, ie nine years or more after it was originally proposed.
Despite not yet being implemented, Solvency II’s main themes already exert a significant influence over regulators. The European Insurance and Occupational Pensions Authority (EIOPA) has proposed that some elements of the regime (including a number of significant reporting requirements) should be applied by national supervisors from 2014. The purpose of this is to ensure that the industry takes adequate steps to prepare for the final regime.
The UK regulator, now the Prudential Regulation Authority (PRA), has always been keen to ensure that firms proactively prepare for the new regime. It has yet to indicate, however, to what extent it intends to comply with EIOPA’s proposals by applying them to UK firms and groups. EIOPA’s proposals are arguably more onerous than necessary at this stage, particularly in relation to regulatory reporting. The PRA is only required, under European law, to ‘comply or explain’.
The Solvency I and Solvency II regimes are primarily targeted at insurance and reinsurance firms and groups based in the European Economic Area. They also apply, or will apply, to non-European firms that have establishments in the EEA.
Apart from this, the Solvency II regime will indirectly affect non-EEA operations in three main ways:
- when firms within the EEA cede risks to firms outside the EEA: in doing so they will then wish to claim credit for this in calculating their technical provisions or regulatory capital. If they cannot, that will create problems for the reinsurance market in the non-EEA jurisdiction in question. We refer to this as the ‘reinsurance issue’;
- when a European insurance group has operations outside the EEA: in that event the question will arise how those operations should be treated for group capital purposes. Can they be taken into account by reference (i) to local rules or (ii) must European rules apply? If (ii) is applied, the face value of the assets may need to be written down significantly. Higher levels of capital may be required, resulting in a corresponding rise in the capital required to be maintained by the EEA group. Even if this is not the case there would be the (sometimes considerable) burden of complying with two sets of potentially incompatible rules. We refer to this as the ‘group capital issue’; and
- when an insurance group headquartered in a non‑EEA jurisdiction has operations in the EEA: in that event the question arises whether European insurance supervisors can rely on the group supervision exercised in the jurisdiction in question. Or does it have to be duplicated by a group supervisor in Europe, either in relation to the group as a whole, or in relation to any subgroup or subgroups of the group within the EEA. We refer to this as the ‘group supervision issue’.
The Solvency II directive provides a procedure for determining whether the regulatory regimes that apply in non-EEA jurisdictions are to be treated as equivalent to Solvency II for each of the three purposes mentioned above. This requires EIOPA to report to the Commission on that question and for the Commission to make a decision based on that report. The relevance of a finding of equivalence is as follows:
- a finding of equivalence on the reinsurance issue means that reinsurance ceded by an EEA firm to a (re)insurer in the jurisdiction concerned is treated for regulatory purposes in the same way as reinsurance ceded to a European firm. The effect is to prevent European supervisors from imposing special conditions, such as requiring the deposit of security;
- a finding of equivalence on the group capital issue reduces the likelihood of operations in the non-EEA jurisdiction in question requiring extra regulatory capital. The danger of this happening arises when the European group supervisor requires the group’s capital to be calculated using the deduction and aggregation method. If the jurisdiction is not found to be equivalent, local operations must then be capitalised by reference to Solvency II, rather than what are likely to be less stringent local rules. A finding of equivalence allows the group supervisor to apply local rules if it so chooses; and
- a finding of equivalence on the group supervision issue means that European supervisors are required to ‘rely’ on group supervision by the relevant non-EEA group supervisor. We discuss what ‘reliance’ means in this context further below.
The outcome of the first applications for equivalence was as follows:
- Switzerland, Bermuda and Japan applied for reinsurance equivalence. EIOPA recommended to the Commission that their applications be granted, subject to some caveats;
- Switzerland and Bermuda applied for group capital equivalence. EIOPA recommended to the Commission that their application be granted, subject to some caveats in the case of Bermuda; and
- Switzerland and Bermuda applied for group supervision equivalence. EIOPA recommended to the Commission that their application be granted, subject to some caveats.
The Commission has yet to make a formal determination on these recommendations.
In amendments proposed to the Solvency II directive (but not yet agreed) in 2011, a regime of ‘transitional equivalence’ was proposed for some other non-EEA jurisdictions not yet ready to be treated as fully equivalent. They were required to satisfy some basic standards including in terms of progression to full equivalence. Furthermore the transitional equivalence regime would not, under the proposed amendment, benefit groups with an artificial structure, where a European insurer in the group had a more significant balance sheet total than its non-EEA parent.
A letter from the Commission dated 2 February 2012 indicates that Australia, Brazil, Chile, China, Hong Kong, Israel, Mexico, Singapore, South Africa and Turkey have indicated an interest in applying for transitional equivalence.
Discussions on mutual recognition are also taking place with the US, although it has not indicated an intention of applying for equivalence. In December 2012 the US/EU Insurance Dialogue Project’s steering committee issued a joint report on the outcome of negotiations. Benjamin Nelson, CEO of the National Association of Insurance Commissioners, reported in June 2013 that ‘significant progress has been made, and we are engaged in advancing common objectives and initiatives over the next five years’.
European insurers at a competitive disadvantage?
There are concerns that the effect of the group capital rules described above may be to put European insurers and groups with worldwide operations at a disadvantage compared to firms and groups elsewhere.
Peter Skinner, the European Parliament’s rapporteur for Solvency II, has commented:
‘The European Parliament’s view is to allow [the insurance industry] to conduct business in other countries around the world where it already has a major foothold, in a way that is actually understood by those local regulators and can be agreed [on] by regulators within the European Union, without tipping it so that we have an ill-effect of causing [firms to pay] extra capital charges just because [of] the regulatory environment in Europe.’
Will Europe really rely on group supervision outside Europe?
The Solvency II directive was originally proposed in 2007. At that time it seems to have been the intention that if a non-EEA jurisdiction, such as Bermuda, was determined as being fully equivalent, European supervisors would then rely on group supervision within Bermuda of Bermuda-based groups. This would be subject to Bermuda convening a college of supervisors to include relevant European supervisors. It would also not prevent those supervisors from continuing to take an interest in group issues and taking them up with their regulated firms or with the Bermuda group supervisor.
The original intention, however, seems to have been that a group subject to equivalent non-EEA supervision would not be subject to distinct supervision in Europe in relation to any European subgroup. There was, for instance, no suggestion of European subgroup supervision in the 2007 proposal.
In advice given to the Commission in 2009 EIOPA’s predecessor, CEIOPS, explicitly stated that a finding of equivalence at ultimate holding company level (eg Bermuda) would rule out subgroup supervision in Europe.
More recently, however, it seems that there has been a change of heart on this issue by EIOPA and/or the Commission. In draft level three guidelines EIOPA stated:
‘Where the parent (re)insurance undertaking (…) is headquartered in a non-EEA country that has a positive equivalence finding or is on the list of countries for temporary/transitional equivalence under Article 260 of the directive, group solvency calculation should be applied at the level of the EEA parent undertaking where an EEA subgroup exists. Where an EEA subgroup does not exist, the EEA supervisory authorities of the EEA insurance undertakings of the group cannot require the establishment of an EEA subgroup for the purpose of applying group supervision.’
It is questionable whether this approach is justified. There is no obvious foundation for it in any version of the Solvency II level one text. Where a non-EEA jurisdiction, such as Bermuda, is determined to be equivalent, article 261 provides for member states to rely on the group supervision exercised in Bermuda. There is no qualification to this.
Where an equivalent non-EEA supervisor is responsible for group supervision and appoints a supervisory college, it will be in communication with the relevant European supervisors. Those supervisors will have power to take action against their regulated firms under article 258 when there are prudential issues affecting the group.
If EIOPA has its way, however, the industry may be subject to as many as four levels of regulatory supervision with as many as four distinct supervisors. The first level would be the solo supervision of each individual EEA (re)insurer by its home state supervisor. Suppose any such firms were members of, say, a Bermuda-based worldwide group and Bermuda was finally determined by the Commission to be equivalent. The group would then be group supervised in Bermuda. If the group had an EEA subgroup or subgroups, those groups would be subject to distinct supervision within Europe, potentially in different jurisdictions. There would also be the possibility of further subgroups lower down the corporate structure being supervised at national or regional level under articles 216 and 217. So there is a danger of significant regulatory overload.
In case this was not enough, EIOPA also now proposes that it should take an enhanced direct supervisory role for the largest important cross-border insurance groups, thus potentially creating a fifth level of supervision.