Andrew Tyrie MP (Chairman of the Treasury Committee) recently described Solvency II as "an object lesson in how not to make law". In similar vein, Andrew Bailey of the PRA has said that Solvency II is "lost in detail" and "vastly expensive".

Draft Guidelines issued by EIOPA in March aim to restore credibility to the Solvency II project and to reassure firms that vast sums spent by them in preparing for the new regime have not been wasted. However the introduction of compulsory reporting and ORSA requirements while Pillar 1 negotiations remain unresolved is controversial. Because the Guidelines have no legal force, there is also a danger that they will fail to secure a "consistent and convergent approach" to preparation for Solvency II.

This briefing examines:

  • Whether Guidelines introducing elements of the Solvency II Directive (the Directive) represent legitimate preparation for the new regime or implementation by the back-door;
  • Firms' exposure to different levels of compliance by national regulators (NCAs) with the Guidelines; and
  • The implications for firms of recent PRA statements about where Solvency II negotiations are headed, including its 23 May update on the European timetable and its approach to implementation.

1. EIOPA's draft Guidelines

Towards the end of 2012, the European Insurance and Occupational Pensions Authority (EIOPA) made clear to the EU Commission its concern that Solvency II negotiations had stalled and the risks associated with not having a clear and realistic timetable for implementing the new regime. EIOPA noted, in particular, that the delays were undermining the EU's position in international discussions.

Over six months later, we still do not have an agreed timetable for implementation of Solvency II. However, at the request of the Commission, EIOPA has issued draft Guidelines that aim to provide a roadmap for NCAs in the lead-up to the new regime.

The Guidelines, which are open for consultation until 19 June, cover the following four areas, which are seen as fundamental to effective preparation for Solvency II:

It was unsurprising to see these four areas covered as they had been well signposted in advance. Understandably, though, concerns have been expressed by industry about the introduction of extensive reporting and ORSA requirements while there is no clear end in sight to Pillar 1 negotiations. EIOPA has at least recognised this difficulty and proposes to review its proposals at the end of 2013 "based on the latest developments". In the meantime, firms are left with still more uncertainty.

EIOPA intends to publish final Guidelines in the autumn. An accompanying press release states that they will apply from 1 January 2014, although there will be some flexibility in their application through phasing-in provisions and the use of thresholds. EIOPA also states that it is up to NCAs to determine how to incorporate the Guidelines into their regulatory or supervisory framework. Unfortunately for firms, the PRA has said that it will only confirm whether it intends to apply the Guidelines once they have been finalised (a message that is confirmed in its 23 May update). This leaves very little time to prepare for the beginning of 2014, in particular, if the PRA needs to consult on rules and guidance giving effect to the Guidelines.

2. EIOPA's power to set the Guidelines

EIOPA undoubtedly has power to issue guidance in some contexts; Article 16 of the EIOPA Regulation provides for the issue of guidance with a view to "establishing consistent, efficient and effective supervisory practices" and "ensuring the common, uniform and consistent application of Union law". It is less obvious, though, whether it was intended that the power would be used in the circumstances now envisaged. In the context of Solvency II, guidance is expected to supplement the legal framework established by the Directive and the more detailed requirements of delegated acts and technical standards, not to act as the instrument of regulatory reform.

3. Compliance with the Guidelines

The Guidelines are intended to ensure that NCAs adopt a "consistent and convergent approach" to preparing for Solvency II. There is a danger, however, that they will not achieve this aim. This is because:

  • Although NCAs are required to "make every effort" to comply with the Guidelines, there is no legal obligation for them to do any more than "comply or explain";
  • Some NCAs will simply not have the legal powers required to impose the Guidelines and to impose additional (Solvency II) obligations on firms. The UK regulatory regime is, perhaps, less rigid than other jurisdictions in this regard as FSMA gives the PRA and FCA extensive rule-making powers for the purpose of their statutory objectives, which could be used to give effect to the Guidelines and to impose their requirements on firms;
  • Other NCAs may have powers to enforce the Guidelines but may decide not to use those powers. The PRA, for example, has not ruled out this approach (see further below).
  • The Guidelines are a minimum harmonisation measure, which means that NCAs can regulate insurers in their jurisdiction more heavily than the Guidelines require. While so much uncertainty surrounds the future outcome of Solvency II negotiations, it seems very unlikely that NCAs will want to dismantle existing regulatory regimes;
  • As between NCAs that do follow the Guidelines, some may require firms to meet the standards specified; others may decide not to.

All of this means that it is uncertain whether the Guidelines will lay the foundations for the harmonised "soft launch" of Solvency II that EIOPA is looking for.

Industry response to the Guidelines

In a letter to EIOPA, Insurance Europe recognises the potential benefits of the proposed Guidelines in maintaining momentum, encouraging readiness for actual implementation and achieving a harmonised approach across jurisdictions. It is, however, opposed to the introduction of compulsory quantitative reporting or ORSA requirements based on Solvency II Pillar I requirements that remain under negotiation. It also calls for confirmation that there should not be a de facto implementation of Solvency II before it becomes legally enforceable. Understandably, firms are concerned that information collected during this period should not lead to rules other than Solvency I being used to determine capital requirements (although, of course, the UK and some other Member States already set capital requirements that exceed Solvency I standards).

In its 23 May update, the FSA addresses this issue by making it clear that the Guidelines are about preparation, not "bringing forward elements of Solvency II early".

4. What has the PRA said about the proposed Guidelines?

The PRA's message to firms about the proposed Guidelines could perhaps be more helpful. It expects firms "to have regard to" the Guidelines and "take appropriate steps to prepare for Solvency II". It also states that firms should assume that the Guidelines will apply to them in full. At the same time, it has specifically reserved its position on whether the UK will comply with the Guidelines until after they are finalised. The PRA's 23 May update indicates that it shares firms' concerns about the introduction of reporting requirements while Pillar 1 negotiations are ongoing.

5. What has the PRA said about Solvency II more generally?

More worrying, perhaps, are recent PRA comments about the broader Solvency II project. In a letter dated 14 February (but only published on 30 April), Mr Bailey confirmed the PRA's expectation that harmonised insurance standards will eventually be agreed. It is less clear, however, what those standards will end up being and whether they will achieve the degree of harmonisation that has been a key objective of the Solvency II initiative.

Mr Bailey suggests that support for Solvency II from France, Germany and Italy has diminished. His comment that it is now not clear that the French authorities will be able to agree to any regime that the PRA considers prudentially acceptable is particularly interesting. In contrast, Germany seems to agree that a relatively prudent Solvency II regime is needed but is looking for a long transitional period. The German insurance sector has particular difficulty with a large "back book" of guarantees, which have become difficult to support in the current low interest-rate environment, and it needs time to adapt to the new requirements.

Particular concerns the PRA has about the regime that could eventually emerge are as follows.

Maximum harmonisation v judgement-based approach

The PRA has made much of its new judgement-based approach to insurance supervision, an approach which depends on supervisory teams being staffed by individuals with the right expertise and experience of the insurance sector. Equally important, however, is a supervisory framework that gives supervisors the flexibility they need to deal with risks effectively and that does not place unnecessary limits on what they can do.

There is a clear tension, therefore, between this approach and a regime that is maximum harmonising and that consists of swathes of rules and guidance that attempt to address every situation that a regulator may face. Unfortunately, the PRA fears that Solvency II may be heading in the latter direction and that it will establish a single approach to risk assessment and supervision that undermines its ability to deal with issues flexibly.

PRA to use early warning indicators

Most of the larger UK insurers are expected to calculate their capital requirements by using an internal model, not under the standard formula. The PRA is concerned, however, that overloading supervisors with detailed model approval requirements conflicts with the exercise of judgement. It also wants to safeguard against firms' over-reliance on models and the use of models to minimise capital requirements. To do this, the PRA plans to use "early warning indicators" to alert supervisors to potential threats to solvency in cases where a model has been used to keep capital requirements as low as possible and its 23 May update clarifies its intention in this regard.

The PRA argues that its use of early warning indicators is consistent with the requirements of the Directive. If it is wrong, which must be possible given that Solvency II is intended to be maximum harmonising, it will nonetheless accept the risk of being challenged. Such a challenge would usually be brought by the EU Commission but there are circumstances in which individual firms can claim damages too.

Non-equivalent third countries

The application of Solvency II measures on the equivalence of supervisory regimes outside the EEA has been the subject of much debate. Mr Bailey recently commented that, if the regime in a jurisdiction outside the EEA is found not to be equivalent to Solvency II, groups with operations in that jurisdiction may find that their capital requirements are significantly increased by comparison to the calculation under local rules.

Use of the word "increased" in this context is perhaps confusing because a group's Solvency II capital requirements should not become greater simply because it is involved in non-equivalent jurisdictions. Perhaps the better point is that, where capital requirements applying in a non-equivalent jurisdiction are relatively low, a group's Solvency II requirement is likely to be higher than if local rules alone applied to operations in that jurisdiction. Although the underlying objective of the Directive is to establish a risk-based regime so as to protect EEA policyholders and not to secure the competitiveness of EEA insurers in non-EEA jurisdictions, it is nonetheless helpful that the PRA is aware of this issue. UK insurers will no doubt welcome Mr Bailey's comment that the PRA should, if necessary, "resist narrow interpretations" in this area.

The PRA is putting in place an approach that aims to mitigate the risks described above and that will reduce the risk that firms' costs soar even further out of control. Mr Bailey argues that the PRA can do nothing, however, about the EU process that is the root cause of the problem.

6. Will the Guidelines achieve their purposes?

In the absence of a legally binding Solvency II regime, it is not certain that the Guidelines will ensure that EEA States take a "consistent and convergent approach" to preparing for Solvency II. EIOPA is relying on its powers under Article 16 of the EIOPA Regulation to issue the Guidelines, which means that NCAs are only bound to "comply or explain". And in the absence of any basis on which compliance can be secured, NCAs can seemingly explain their non-compliance without fear of further recourse.

Clearly, the Guidelines are intended to underline that Solvency II is back on track. In reality, only final agreement on the remaining issues and a properly planned timetable for bringing the Directive into full force can achieve this. Until then, doubt must remain about the final shape of the new regime. Indeed, despite confidence expressed by Andrew Bailey that it is "politically highly unlikely that the EU will operate long term without harmonised standards for insurance", it does still remain questionable whether there will ever be a new regime at all.