Most that has been written to date about Solvency II concentrates on technical aspects of the proposal. This is the first in a series of articles we are planning to write on legal issues raised by the project. The issues discussed in this article are likely to be of particular interest to insurers and reinsurers already operating in a number of European jurisdictions and who are perhaps considering consolidating their operations into a single EU entity.

The European Commission published its proposal for a Solvency II Framework Directive (Framework Directive) in July 2007. The FSA recently predicted that the new regime will take effect from2012/20131. Despite this, legal issues raised by the text need to be dealt with now as the legislationmay be finalised as early as the end of 2008.

The Framework Directive’s provisions are intended to be principles-based. They will in due course be developed through Level 2 implementingmeasures provided for within the four-level Lamfalussy framework, which was extended to insurance in 2004. Level 2 measures will also be adopted well before the new regime comes into force and therefore require careful review at an early stage.

Success of Solvency II depends on supervisory convergence

The Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) recently noted2 :

“One of the success factors of Solvency II will be the extent to which supervisory convergence between EU supervisors can be achieved while implementing the system. Indeed, the effect of…harmonisation…will be significantly reduced if the supervisory process cannot achieve an adequate degree of convergence.”

CEIOPS’s comments relate specifically to Solvency II. They are timely, however, given the ongoing review within Europe of how well the Lamfalussy architecture is serving the needs of financial servicesmarketsmore generally (Lamfalussy Review). Lamfalussy was designed to streamline European procedures for adopting financial services legislation and to provide a structure for cooperation between national supervisors. Solvency II is the first insurance project to fall within its scope.

Whether supervisory convergence is achieved in the context of Solvency II will inevitably depend to a large extent on cooperation betweenMember States. However, legal issues discussed below will also influence the extent to which the Solvency II regime is implemented consistently throughout the EU.

A pan-European regulator?

Distinguishing between supervisory convergence (how national supervisors put European rules into practice) and regulatory convergence (agreement of a common set of rules), the UK view is that “consistent with a principlesbased approach, supervisory convergence is primarily about delivering equivalent regulatory outcomes”3. One way of being sure of achieving such equivalence would be to replace national supervisors with a pan-European regulator applying a single set of rules. This is not an option that the UK favours. As Kitty Ussher, Economic Secretary to the Treasury, recently explained4:

“a one-size-fits-all supervisory approachwith a common rulebook, or a pan-European regulator,would be insufficiently flexible to allowall themarkets of the EU to flourish,which is whywe reject it, very simply, on economic grounds.”

CharlieMcCreevy, European Commissioner for Internal Market and Services, also recently acknowledged5 that, while he could see arguments for and against such a proposal, he saw “no chance” of getting political agreement to such a radical change in the regulatory framework.

So how can supervisory convergence be addressed in other ways, while providingMember States with the flexibility they need to adapt regulatory requirements to reflect national differences in insurancemarkets?

Minimise national discretion

Most obviously, the less discretionMember States have under European legislation, the less the scope for national differences in implementation. Recognising this, the European Council ofMinisters (Council) recently6 gave an undertaking to limit the use of national discretions and “gold-plating” in legislation to theminimumextent necessary and has invited the European Parliament (Parliament) to do likewise.Whether or not Solvency II is consistent with this undertaking at themoment or when fully in force will depend upon an article-by-article analysis of the Framework Directive and, in due course, the Level 2 implementing measures. There is no doubt, however, that it goesmuch further than the existing insurance solvency regime towards achieving regulatory convergence in the terms envisaged by the Council.

Assuming that national discretions included in the Solvency II regime are kept to aminimum, effective implementation will still depend to a significant extent on the exercise of discretion by individual supervisors. For example, qualitative assessmentsmust bemade of the suitability of internal governance arrangements and internalmodels. The Pillar 2 supervisory review process also relies heavily on the exercise of discretion at a national level.

Incorporate parameters for the exercise of discretion

One way ofminimising the extent to which regulatory approaches to the exercise of such discretion can vary is to incorporate appropriate limits into the legislation itself. For example, whilst approval of internalmodels is amatter for the home state supervisor, the Framework Directive establishes a number of requirements thatmust bemet in each case, including satisfaction of the use test and meeting standards of statistical quality, calibration, validation and documentation.

A similar approach has recently been used in European legislation establishing new requirements for changes of control of insurance (and other financial sector) companies7. The European Commission recognised that there is currently a lack of legal certainty about how national supervisors should assess whether to approve a proposed change of control, whichmay be impeding corporate activity in the financial sector. It has therefore decided to specify the criteria against which an application to acquire controlmust be assessed. Any decision not to approve a change of control will have to be justified on the basis of those criteria.

Supervisory convergence within the context of Lamfalussy

The Lamfalussy arrangements were established for securitiesmarkets in 2001 and subsequently extended to banking and insurance in 2004. A four-level approach to financial services regulation (see box for details) was designed to increase the efficiency of the European legislative process and lead to greater consistency in supervisory practices as betweenMember States.

The Lamfalussy approach applied to insurance

The Lamfalussy approach separates the regulatory framework into four levels (For Table click here )

So, Level 1 measures (including the Framework Directive) primarily establish high-level principles, or political choices, underpinning the regulatory regime. Level 1 measures also establish the extent to which the European Commission should be required to put in placemore detailed technical rules (Level 2 measures) for implementing policy determined at Level 1 – a key advantage of such an approach is that Level 2 measures can be changed with relatively little formality as compared withmaking amendments to Level 1 measures.

In the case of Solvency II, achieving the right balance between Level 1 and Level 2 measures is an important factor in ensuring that, unlike the current regime, the new requirements can be adjusted in line with futuremarket and industry developments. In terms of achieving the regulatory convergence that promotes consistency in supervision, it is also important to ensure that Level 1 and 2 measures are sufficiently closely defined, while giving supervisors the flexibility they need to deal with national market differences.

Promotion of supervisory convergence through Level 3 Committees

Lamfalussy also plays an important part in promoting supervisory convergence through the work of its Level 3 Committees, including CEIOPS. CEIOPS’s responsibilities on Solvency II include producing guidance for use by Member State supervisors in implementing the requirements of the new regime.

Commentsmade in relation to the Lamfalussy Review confirmwidespread agreement of the importance of Level 3 guidance in promoting best practice but indicate that there is scope for improving its effectiveness in terms of achieving greater supervisory convergence. These include: 

  • greater accountability of Level 3 Committees to the Council and Parliament; 
  • a proposal that national supervisors’mandates should include an obligation to cooperate with the EU and to work towards supervisory convergence; 
  • increased use of impact assessments on Level 3 guidance; 
  • the introduction of a “comply or explain” regime, coupled with a comprehensive systemof peer review; and
  • the introduction of qualifiedmajority voting into Level 3 Committees’ decision-making procedures.

Even with these changes, Level 3 guidance is non-binding. This can be detrimental in terms of achieving supervisory convergence, in particular, as it appears that some national regulators will sometimes even issue their own guidance that is inconsistent with Level 3 guidance. The European Commission recently looked at this issue and suggested8 it might be tackled byMember States stating in an ECOFIN declaration that they would request their regulators to agree to the full application of Level 3 guidance.

Supervisory cooperation is no substitute for harmonisation

As described above, Lamfalussy plays an important part in ensuring that supervisory cooperation is integral to the regulatory framework. However, in the absence of political agreement, there are limits on what can be achieved at a supervisory level. CEIOPS recently noted9 that:

“the current distance to go towards a higher level of harmonisation of the EU regulatory framework represents one of themost fundamental challenges to increased supervisory convergence…Supervisory authorities cannot and should not be expected to find solutions where the political process has not led to clear and reliable results.”

So, if the politicians have left issues to be resolved as a matter of national discretion, it is not for supervisors to second guess that position. CEIOPS has said that it is using the Solvency II project to target specific areas of concern in this regard, including rules on the valuation of assets and liabilities.

Consolidation of existing legislation – a chance to improve convergence

Solvency II capital requirements are incorporated into what is effectively a consolidation of 13 directives that currently deal with insurance and reinsurance. This is being done by applying the “recasting technique”, which shouldmean that the Framework Directive does not include any substantive changes fromthe existing regime except to the extent necessary to implement the new capital requirements.

Putting existing insurance legislation into one directive is welcome as it is extremely difficult to work with 13 different texts at once. However, applying the recasting technique does raise some concerns in terms of future supervisory convergence. 

  • No opportunity to review existing areas of uncertainty - Errors and ambiguity already existing in the legislation will be carried over into the Framework Directive without amendment. This will prolong differences in interpretation betweenMember States. 
  • Additional uncertainty created by applying the “recasting technique” - In some instances, the consolidationmay itself create uncertainty about themeaning of provisions that previously stood on their own. For example, Article 18 of the Framework Directive arguably casts doubt on whether direct insurers will in future be able to act as holding companies.

Conclusion

Supervisory convergence in implementation of the Solvency II regime will only be achieved ifMember State supervisors are willing to trust and cooperate with each other. Legal obligations and constraints contained in the Framework Directive and Level 2 implementingmeasures can only have limited effect in the absence of such cooperation, although proposed changes to the Lamfalussy framework, including the introduction of qualifiedmajority voting, are further steps in the right direction.

Both the UK authorities and CharlieMcCreevy have expressed the view that supervisory convergence can only be achieved over time and cannot be achieved through regulation. Given this, considerations above can perhaps move the process in the right direction.