Solvency II update

Timing

The Solvency II Directive was formally passed by the European Parliament at the end of 2009. As made, it required Member States to transpose Solvency II into national law by 31 October 2012.

From the outset, that choice of date was regarded as odd. Given that Solvency II operates on a balance sheet basis, any firm with a balance sheet date of 31 December would effectively have been required to apply Solvency II during 2012 in order to comply with the Solvency Capital Requirement as at 31 December 2012. This was apparently not the intention, and it was therefore proposed that the date be moved back two months to 1 January 2013, so that the new rules applied from 2013. That proposal was made in mid-2010, but the Solvency II Directive was not amended. The change of date was intended to be introduced as part of Omnibus II (which is a further directive, designed to amend the Solvency II
Directive by introducing transitional provisions and providing for the “Lisbonisation” of the delegated rule-making process).

The original intention was that the final rules (including the Level 2 measures) should be settled at least one year prior to implementation, thus giving firms reasonable notice of the new rules. As the Level 2 and Omnibus II negotiations continued during 2011, it became apparent that there would not be enough time to finalise those measures by the end of 2011, thus leaving less than a year between rule finalisation and commencement. As the months rolled on, a delay – or extensive transitional relief – became inevitable.

The problems with implementation went beyond a debate over timing. Regulators across Europe were not convinced that they had the power to entertain internal model applications until Solvency II entered into force, whenever that was. This meant that firms seeking internal model approval would not know until some months after the commencement of the regime what their required level of capital was. Clearly this was unacceptable, both to firms and to regulators.

This dilemma gave rise to the idea of splitting (or, as it became known, “bifurcating”) the start date into separate transposition and commencement dates. In other words, the regime would need to be transposed into national law some time prior to the rules actually being applied to firms, thus giving regulators an interim period in which to consider and pre-approve internal model applications. When the FSA first confirmed the bifurcation approach in October 2011, that interim period was to be one year (i.e., national transposition by 1 January 2013 and “go live” for firms on 1 January 2014). However, ongoing delays in the timetable for finalising Omnibus II and, in turn, the Level 2 measures meant that 1 January 2013 became unachievable.

Matching adjustment

The main source of political disagreement over Omnibus II – and, therefore, the main cause of Solvency II’s ongoing implementation delays – is the discounting of long-term insurance products that are backed by fixed-interest investments. This may seem an obscure point, but potentially billions of pounds/euros are riding on the outcome.

The basic concept is that long-term insurers purchase fixed-interest investments with a matching maturity profile to back their liabilities. The Solvency II economic balance sheet requires marking-to-market for assets. Accordingly, if the market demands an increased return on illiquid fixed-interest investments (thereby forcing the principal value of those investments down) then that reduction in value must be recognised by insurers holding those investments. This in turn creates a gap in the value of the liabilities and the matching assets, as the liabilities continue to be discounted at the lower risk-free rate.

The argument is that if such a reduction in value is solely attributable to illiquidity (rather than, say, an increase in credit risk), it is not relevant to insurers who are holding the investments to maturity. The matching adjustment is therefore designed to off-set such losses on the asset side with an increase in the discount rate applied to the associated liabilities, thus proportionately reducing the present value of those liabilities and therefore closing the gap.

Tied up with the matching adjustment issue are concerns about the effect of such an adjustment (or its absence) on future annuity rates, the viability of existing annuities and the behaviour of insurers as investors. These concerns tends to weigh in favour of allowing generous concessions for insurers, however this is in tension with the overall aim of prudential regulation, which is to ensure the financial security and soundness of insurers.

Reinsurance recoverables

The following apply when bringing reinsurance recoverables into account under Solvency II:

• the recoverable must be valued as a separate asset (not netted off ceded liabilities) and that asset valuation must itself reflect ordinary-course counterparty risk;
• the reinsurance also generates a separate counterparty risk charge in the SCR, against which capital must be held (SCR module: counterparty default risk); and
• the reinsurance can be netted off ceded liabilities in calculating the SCR underwriting risk charge, but only if the risk mitigation criteria are met.

If the risk mitigation criteria are not met, the reinsurance is generally 100% de-recognised immediately (subject to a recovery period allowance for SCR breaches by the reinsurer). These criteria include requirements about the following:

• counterparty status (the reinsurer must meet its SCR or equivalent or be credit quality step 3), unless qualifying security/collateral arrangements are in place;
• the reinsurance must provide an effective transfer of risk;
• the reinsurance must be legally effective and enforceable in all relevant jurisdictions; and
• the reinsurance must not be finite/financial reinsurance

Treatment of VIF

Currently, contingent loans (and similar) enhance core Tier 1 capital because the repayment obligation is ignored if it is unambiguously linked to the emergence of surplus. This rule cannot survive Solvency II transposition.

Under Solvency II, contingent repayment obligations will need to be recognised, thus reducing (and potentially eliminating) any Tier 1 uplift from contingent loans.

Valuation of technical provisions under Solvency II includes all cash flows (in and out) within the contract boundary. This can include expected profits included in future premiums (“EPIIFP”). EPIIFP is not as extensive as VIF, however it is included in Tier 1 via the reconciliation reserve (i.e., without monetisation).

The quantum of an insurer’s EPIIFP is subject to the contract boundary. The contract boundary sets a time limit around the length of each insurance and reinsurance contract for the purpose of determining that contract’s cash flows. In summary, a short contract boundary means that subsequent cash flows (including future premiums and profits thereon) cannot be recognised. Accordingly, the extent to which EPIIFP is valuable as an own fund item depends on the length of the contract boundary for long-term business.

With-profits

The FSA proposes that the long-term fund concept will no longer exist as a prudential requirement post-Solvency II. Instead, long-term insurers will be free to organise themselves internally as they wish, subject to any conduct rules concerning the segregation of certain asset pools and the new Solvency II rules concerning ring-fenced funds.

The FSA also proposes a series of conduct (rather than prudential) rules which require with-profit funds to be demarcated through separate accounting records and through limitations on the circumstances in which the assets allocated to a with-profits fund may be transferred out of that fund. The effect of these conduct rules is to bring with-profits funds squarely within the definition of a ring-fenced fund for Solvency II purposes. This gives rise to a prudential consequence, namely that:

• a notional SCR must be calculated for the ring-fenced fund; and
• any own funds within the ring-fenced fund that exceed the notional SCR cannot be used to meet the entity’s SCR (amounting to a tier 1 deduction at entity level, via the reconciliation reserve).

A further change to the prudential treatment of with-profits funds is proposed, namely that “approved surplus funds” can be excluded from technical provisions for with-profits business. These “surplus funds” are accumulated profits that have not yet been made available for distribution to policyholders and meet the tier 1 loss-absorbency criteria. They may become relevant to with-profits insurers in run-off as a means of ensuring that whilst all assets in a closed with-profits fund will in principle be distributed to policyholders over time, some of those assets are not yet allocated for distribution and may therefore be used to increase own funds within the ring-fenced fund.

Internal models

It has now clear that the PRA, the new regulator for general insurers, life offices, reinsurers and the Lloyd’s insurance market, will have to continue to operate the existing FSA financial rulebook (the ICAS regime) for several years before the Solvency II rules take effect. Many insurers have been developing internal models for SII implementation (originally planned for 2012/2013). Firms may or may not wish to use these models under the ICAS regime. If they do, they will have to provide FSA with a ‘reconciliation’ between the calculations to take account of the differences in the two regimes. Firms that satisfy FSA will then be permitted to use the SII internal model and balance sheet for ICAS purposes without further reconciliation.