WHAT HAS BEEN AGREED?

The Commission, the Council and the European Parliament agreed in November on the final text of the 'Omnibus II Directive'.

This directive, together with a complementary 'quick fix directive':

  • formally postpones the commencement of the Solvency II regime to 2016;
  • adapts the original 2009 Solvency II Directive to the Lisbon treaty structure;
  • enhances the role of the European Insurance and Occupational Pensions Authority (EIOPA) within the Solvency II regime;
  • contains further provision for delegated legislation supplementing the directive;
  • ddresses a number of controversial policy issues, including how the regime deals with:
    • long term guaranteed products;
    • sovereign debt;
    • third country insurers with operations in Europe; and
    • EU insurers operating in third countries.

TIMING 

Commencement

The rules applying the Solvency II directive as amended are now required to be adopted by member states by March 2015. They should apply from 1 January 2016. This is a tight schedule. There is still a lot of work to be done by all parties concerned.

Within the UK, the transposition will mostly be given effect in the Prudential Sourcebook for Solvency II Insurers (SOLPRU). Some of the material within SOLPRU has already been developed in draft. Other sections will follow next year. Much of SOLPRU merely gives more or less literal, or 'copy out', effect to the directive. There are, however, areas where member states will have more leeway in the implementation of the directive. The regulation of with-profits and unit-linked products, for instance, are two areas where member states have discretion.

Interim regime

An interim regime based on guidelines already issued by EIOPA is to apply from 1 January 2014. This is aimed at ensuring that the industry prepares appropriately in the period leading up to commencement. We discussed EIOPA's proposals in the October issue of Insurance and reinsurance news.

Member states' competent authorities were required to 'comply or explain' with EIOPA's proposals. The UK Prudential Regulation Authority has consulted on proposals within a draft supervisory statement involving complying with the EIOPA guidelines. The PRA's consultation states that it 'has been proportionate in the application of the guidelines, to minimise the risk of periods of dual running'. A final version of the supervisory statement should be published before January next year.

Delegated legislation - potential for further delay?

The directive will be supplemented by binding 'delegated acts' and technical standards and by further guidelines to be issued by EIOPA. There will be a considerable volume of this material. Much of it is not due to be published in draft until June or September 2015. It seems unlikely that it will all be ready before the regime commences.

When Solvency II was first proposed in 2007 it was described by the Commission as 'principles based'. What is now proposed, however, will introduce much more detailed compliance requirements. Some of these are now hard coded into the directive text, which will make future amendment in light of experience an unwieldy process.

The complexity of the regime significantly narrows the supervisory discretion of member state supervisors. It also arguably creates a tension with the regulatory agenda of the UK Prudential Regulation Authority (PRA). The PRA 'considers it important that the technical detail of Solvency II leaves scope for supervisors of individual insurers to make informed judgements about risks posed, and action to be taken, within a clear overall EU-wide policy framework'. This view seems to be shared in some other member states. Thomas Steffen, German State Secretary, has warned the Solvency II legislators:  'don't make things too complicated'.

Initial drafts of the delegated acts were given limited circulation in 2010 and 2011. A further draft will now be prepared by the Commission early next year. The Commission will submit it to the European Parliament, but there is no requirement for a public consultation. If the Parliament raises objections, there is a risk of the timetable being further delayed, particularly since the focus of MEPs will be taken up in 2014 by the European elections.

Public consultations will, by contrast, take place in relation to the technical standards and guidelines. Experience suggests that responses to consultations on this material are most likely to have impact if channelled though industry bodies.

The delegated acts and technical standards will, in contrast to the directive itself, be directly effective in the law of member states. So they do not need to be incorporated into SOLPRU.

MAJOR POLICY ISSUES RESOLVED BY THE TRIALOGUE AGREEMENT

We now focus on the major policy issues resolved by the trialogue agreement.

Long term guarantees

The most difficult issue resolved by the trialogue agreement was the regulatory treatment of long term guaranteed (LTG) products.

A key high level principle of Solvency II is that it should be market consistent. This involves marking to market assets matching liabilities. Technical provisions are discounted using a 'risk-free' rate linked to government securities.

It became apparent, however, in the course of quantitative impact studies undertaken by the Commission and EIOPA, that strict application of this principle had negative consequences in some member states. When financial markets are depressed it would require firms significantly to increase their technical provisions and consequently the cost of their products. The industry argued that this was not appropriate where the assets were held against LTG liabilities. In that event years of movement in the markets would take place before the liabilities were likely to be called upon and the assets realised.

The solution to this problem agreed in the trialogue involves applying:

  • a matching adjustment (MA) and a volatility adjustment (VA) to mitigate the harshness of the mark to market principle; and
  • an adjusted transitional risk-free interest rate term structure on a reducing basis over a 16 year period toexisting business. The purpose here is to mitigate the effect of exaggerations of bond spreads. Existing business refers to business concluded before 1 January 2016.

There was much initial resistance from other member states to this approach. To meet these concerns the trialogue agreement applies the following 'safeguards', which introduce a significant compliance burden:

  • supervisory approval is required for application of the LTG measures;
  • the relevant insurance supervisor has the power to limit the impact of the transitional measure on technical provisions and is required to apply enhanced supervision in the application of the transitional measures;
  • enhanced monitoring is required for all LTG measures;
  • a capital add-on may be applied if the supervisor concludes that the risk-profile of the firm deviates significantly from the assumptions underlying the LTG measures;
  • firms are required to develop liquidity plans for the VA and MA; and
  • various transparency requirements are applied, including that firms should publicly disclose the impact ofnot applying these measures on their financial position, i.e. the measures improve their balance sheet.

Equivalence

Solvency II treats some third countries as 'equivalent', when they meet certain criteria. Such a finding of equivalence:

  • allows in certain circumstances insurance groups in the EEA to apply local rules to the determination of the regulatory capital of their third country holdings, where the Solvency II rules would have a more onerous effect. This helps those groups to maintain a healthy level of group capital and to compete on equal terms in the third countries in question ('group capital equivalence'); and
  • provides for the group supervision of insurance groups head-quartered in those countries but with holdings in the EEA to be 'relied upon' within the EEA. This reduces the need for that group supervision to be duplicated within the EEA ('group supervision equivalence').

Only Bermuda and Switzerland have been determined as equivalent for these purposes.

So to prevent problems involving insurance groups connected to other jurisdictions, a system of 'provisional equivalence' was developed, the details of which have now been agreed. This allows those jurisdictions to be treated as equivalent, subject to certain criteria in relation to the sophistication of their prudential regimes being met. Those criteria are less rigorous than are applicable to third countries seeking 'permanent equivalence'.

So far as group supervision equivalence is concerned the co-operation of the third country is required to establish provisional equivalence and that equivalence lasts for an initial period of 5 years.

So far as group capital equivalence is concerned it is not necessary for the third country to co-operate and the provisional equivalence lasts for 10 years initially. This meets the problem for insurance groups that certain third countries, including the USA, are not actively seeking to establish that they are equivalent.

Where does this leave Bermuda and Switzerland? Will they enjoy any tangible advantage from their 'permanent' status? Whether they do or not will not become clear until we have the level 3 guidelines on the subject which the Commission have indicated will be published.

The guidelines may also address an additional concern for equivalent third countries. The third country may supervise an insurance group based in that country which incorporates a group or sub-group based in the EEA. The Commission takes the view that reliance within the EEA on equivalent supervision at the top level of the group does not rule out group supervision of the sub-group(s) within the EEA. For that matter it also does not rule out solo supervision. How these distinct levels of group supervision will interact remains to be seen. In any event the Commission's view that sub-group supervision is required in such circumstances may be open to challenge.

Sovereign debt

The financial crisis has demonstrated that debts due from some member states may not be free of risk. Yet the Solvency II directive has maintained the position that sovereign debt should not carry a capital charge. In fact, sovereign debt is not explicitly mentioned in the agreed trialogue text (perhaps because the issue is so sensitive), but the Commission is to:

'review the appropriateness of the methods, assumptions and standard parameters used when calculating the Solvency Capital Requirement standard formula within five years of the application of the Directive.'

In the meantime EIOPA and the Commission will have power to adopt 'technical standards, laying down quantitative limits and asset eligibility criteria where those risks [presumably the risks arising from the asset holdings] are not adequately covered by a sub-module of the Solvency Capital Requirement'.

Issues have arisen as to what actually qualifies as 'sovereign debt'. EIOPA is accordingly to establish 'lists of regional governments and local authorities, exposures to whom are to be treated as exposures to the central government of the jurisdiction in which they are established'.

GRANDFATHERING AND TRANSITIONALS 

There are a range of new grandfathering and transitional provisions, the most notable of which are as follows:

Run-off

Solvency II will not apply to firms which go into run-off by 1 January 2016, if they satisfy their supervisor that they will terminate their activity before 1 January 2019. Many firms in run-off, or contemplating run-off, particularly those with long tail liabilities, will doubtless struggle to meet this timetable.

Solvency I compliant capital

Some capital instruments compliant with the current (Solvency I) regime may be grandfathered under the conditions set out in article 308b(6). The cut off date is the earlier of  the 1 January 2016 commencement date and the date when the delegated acts are adopted, which will probably be in the latter part of 2014.

The PRA has, however, indicated in the paper explaining its approach to insurance supervision that it objects to UK firms taking advantage of this:

'Until Solvency II criteria are fully implemented, the PRA expects insurers to anticipate the enhanced quality of capital that will be needed when issuing or amending capital instruments.'

THE PROPOSED GLOBAL INSURANCE CAPITAL STANDARD - SOLVENCY III? 

In October 2013 the International Association of Insurance Supervisors announced its plan to develop a risk based global insurance capital standard by 2016. Full implementation is to begin in 2019. This will follow two years of testing and refinement with supervisors and with the internationally active insurance groups who will be affected. Hugh Savill of the Association of British Insurers has commented:

'For European insurers in particular, we face the prospect of introducing Solvency II in 2016, only to have to amend it by 2019 to meet a different global capital standard.'