In a previous Sidley Update, we commented on the background and impact of the European Commission’s first series of equivalence decisions under Solvency II,1 which concerned Switzerland, the United States, Bermuda, Australia, Brazil, Canada and Mexico. In its most recent announcements, on November 26, the European Commission adopted Delegated Decisions on the equivalence of the solvency regimes in Bermuda and Japan.
This Update discusses the scope of the equivalence decisions for Bermuda and Japan and considers the UK Prudential Regulation Authority’s (PRA) expectations with respect to group supervision under Solvency II for groups containing a UK insurer which are headquartered in non-equivalent jurisdictions.
Bermuda has achieved a determination of “full” equivalence, i.e., equivalence for an unlimited period, with respect to the three areas of the Solvency II equivalence regime:
- Reinsurance (Article 172) — This relates to reinsurance activities of firms located outside the European Economic Area (EEA), i.e., “third countries.” Where the solvency regime of a third country is deemed to be equivalent to Solvency II, reinsurance contracts between EEA insurers and reinsurers in that third country will be treated in the same way as reinsurance contracts concluded between EEA firms.
- Group solvency (Article 227) — This applies to EEA groups with third country subsidiaries. If a determination of equivalence is made, EEA groups using the “alternative method” for calculating group solvency will be allowed to apply the local calculation of capital requirements with respect to their third country subsidiaries instead of applying a Solvency II calculation.
- Group supervision (Article 260) — Where a parent company of a group of EEA firms is in a third country, a determination of equivalence would mean that the EEA supervisors would rely on the group supervision of that third country.
This new decision for Bermuda replaces the previous decision made by the European Commission on June 5, in which Bermuda was granted only provisional equivalence for group solvency under Article 227 along with Australia, Brazil, Canada, Mexico and the United States. That decision was made on the basis of advice issued by the European Insurance and Occupational Pensions Authority (EIOPA) to the Commission. Following Bermuda’s adoption of new insurance legislation in July of this year, EIOPA updated its advice on July 31. Based on that updated advice, the Commission has now determined that the solvency regime in Bermuda for (re)insurers and groups meets the criteria for full equivalence, with the exception of captives and special purpose insurers, which are subject to a different regulatory regime.
Japan, which was noticeably absent from the Commission’s first wave of decisions, has been granted temporary equivalence under Article 172(4) of the Directive and provisional equivalence under Article 227(5), which relate to reinsurance and group solvency, respectively.
A determination of temporary equivalence under Article 172(4) is valid for five years and will end on December 31, 2020. At that point, the Commission can undertake assessments of the development in the third country’s regime, which would give rise to either a determination of full equivalence or non-renewal of temporary equivalence. Temporary equivalence may be extended by up to one year where necessary to allow EIOPA and the Commission to assess how the regime has evolved over the period.
A determination of provisional equivalence under Article 227(5) is valid for 10 years, at the end of which the Commission has the option to: grant full equivalence; not renew the determination; or, unlike with reinsurance above, renew its determination of provisional equivalence under Article 227(6).
Although Japan had originally sought full equivalence for reinsurance only, it has been granted equivalence for a limited duration for both reinsurance and group solvency. The Commission has the ability to make an equivalence determination in relation to group solvency without a country expressly seeking it.
What does reinsurance equivalence mean for Bermuda and Japan?
The decisions regarding Bermuda and Japan provide long-awaited certainty in the treatment of reinsurance contracts between reinsurers in these countries and EEA cedants.
A reinsurance equivalence decision means that EEA Member States cannot give less credit for third country reinsurance than for equivalent reinsurance with an EEA reinsurer. In addition, Member States cannot require the pledging of assets to cover unearned premiums and outstanding claims provisions in relation to such reinsurance contracts (Article 173), nor can they require the localization of assets representing reinsurance recoverables within the EEA (Article 134).
If a third country is deemed not to be equivalent, reinsurers in that third country could be required to post collateral with respect to the risks they are reinsuring in the EEA, placing them at a competitive disadvantage to EEA reinsurers. Unrated reinsurers in non-equivalent jurisdictions are at a particular disadvantage as, under the standard formula, EEA cedants are required to apply higher capital charges for counterparty default risk for unrated reinsurers in non-equivalent jurisdictions compared with the charges applied to unrated reinsurers in equivalent jurisdictions.
Timing and the PRA’s expectations for group supervision
The equivalence decisions regarding Bermuda and Japan are subject to review and ratification by the European Parliament and Council, for which the time limit is three months, with a potential extension period of a further three months. Once the decisions enter into force, they shall apply from January 1, 2016.
Given that the European Parliament and Council’s three-month window for review extends beyond the implementation date for Solvency II, those EEA firms that are part of an insurance group with a Bermudian parent will still need to consider the implications of group supervision under Article 260 for a period of a few months at least.
In the absence of a determination of equivalent group supervision, EEA Member States can apply the relevant Solvency II requirements to the worldwide group as if it were based in the EEA, or they can apply “other methods” to ensure appropriate supervision of the group, in accordance with Article 262. The only specific example of “other methods” given in the Solvency II Directive is the establishment of an insurance holding company in the EEA.
Whereas in most EEA jurisdictions it would seem that national regulators will treat Bermuda as equivalent for group supervision purposes pending formal confirmation of the decision by the European Parliament and Council, the PRA is taking a different approach in that it is requiring UK subsidiaries in a group with a Bermudian parent to commit to certain “other measures” for an interim period, including, for example, enhanced reporting of intra-group transactions.
A key remaining issue is how group supervision will apply to UK insurance subsidiaries in groups headquartered in non-equivalent third countries, notably the United States. The PRA has been coordinating with the UK insurance subsidiaries of those groups with a view to agreeing appropriate “other methods” to be adopted to avoid implementation of group supervision at the level of the third country parent. In the absence of such agreement and given that the PRA does not have jurisdiction over the wider non-EEA group, the PRA could instead seek to increase the capital requirements for those UK insurers that do not agree appropriate waivers with the PRA.