Key Positions on Own Funds under Solvency II. Gesamtverband der Deutschen Versicherungswirtschaft e. V.

Transcription

1 Gesamtverband der Deutschen Versicherungswirtschaft e. V. Key Positions on Own Funds under Solvency II Gesamtverband der Deutschen Versicherungswirtschaft e. V. GDV

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3 Key Positions on Own Funds under Solvency II

4 Imprint Published by: German Insurance Association Risk Management Department Wilhelmstraße 43 / 43 G, Berlin, Germany phone +49 / 30 / fax +49 / 30 / Contacts: Dr. Thomas Schubert Hans-Jürgen Säglitz Mirko Kraft Dr. Kathrin Schädlich Götz Treber September 2007 GDV 2007

5 Contents 3 Contents Introduction Choosing the total balance sheet approach as guiding principle in determining own funds Recognising surplus funds as own funds of the highest quality without any restrictions Assessing the quality of capital items in an economic manner Taking into account the interaction of own funds and the supervisory ladder of intervention Aligning banking and insurance rules Not including additional prudence outside of capital requirements Allowing group support to replace own funds on solo level Assessing hybrid capital elements economically Accepting the special model of funding mutuals (supplementary members call) Aiming at a harmonization of accounting and Solvency II...33 References...35 Abbreviations/glossary/definitions...39

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7 Introduction 5 Introduction Solvency II is a key project of the European Commission. It will replace the current European insurance directives (Solvency I) with its rules on required capital (solvency margin) and on available capital (available solvency margin). In aiming to establish an economic risk-based solvency framework for the European insurance market not only the calculation of capital requirements will change fundamentally but also the determination of eligible elements to cover these capital requirements ( own funds in the terminology of the draft directive) will have to be redesigned. The main purpose of insurance supervision is to protect policyholders. Its achievement requires insurers to have a stable financial position. An adequate level of capital is needed by financial institutions to absorb the losses incurred by the risks of their operations. The function of own funds is to serve as a financial buffer. 1 Through this paper we will not use the term equity instead of own funds when referring to regulatory capital which may cover capital requirements (although sometimes assumed as being synonyms). By using own funds we want to avoid confusion with (existing) accounting definitions of equity. In this brochure equity refers to an accounting view of capital independently of the applied accounting standard. It is important to note the difference in capital requirements on the one hand and eligible capital to cover the capital requirements (own funds) on the other. The solvency of an insurance company can be assessed by means of the ratio between own funds and the capital requirement. If this ratio is 1 then the insurer fulfils the solvency requirements. Under Solvency II two different capital requirements will have to be met by insurance companies: the Solvency Capital Requirement (SCR) and the Minimum Capital Requirement (MCR). Changing available capital Protecting policy holders by own funds Definition of equity vs. own funds Required vs. eligible capital 1 Cf. CEIOPS [2006], Consultation Paper 20: Draft Advice to the European Commission in the Framework of the Solvency II project on Pillar I issues further advice, p. 50.

8 6 Introduction Function of SCR and MCR The SCR will be calibrated to a certain confidence level which is described by a 99.5% VaR using a one-year time horizon. The MCR is defined as capital level representing the final threshold that triggers ultimate supervisory measures in the event that it is breached. In both cases the capital items which are to be counted as own funds have to be defined either in a principle-based way (criteria which describe the characteristics of own funds) or rule-based by means of a catalogue listing capital items. We would like to highlight the connection between the calculation of capital requirements and the assessment of eligible capital to cover capital requirements. If for example risks arise from assets valued at their market value (e.g. using a stock market volatility) these assets have to be valued consistently (at market values) if used in determining own funds. Total balance sheet approach Aiming at a single set of accounts but differences have to be accepted if justified As guiding principle capital requirements and eligible capital to cover them (own funds) should reflect a risk-based economic view. Hence, we strongly support the total balance sheet approach in determining own funds. Many of the questions this paper is dealing with would not arise if this approach was chosen. Having in mind the aim of convergence with the banking sector the risk-based economic view should lead the way. An alignment between banking and insurance rules on the eligibility of capital elements is also of significant importance for financial conglomerates. 2 An additional objective should be a harmonization of accounting and Solvency II: There are clear advantages from being able to utilise the same or similar platforms to derive accounting and regulatory figures ( single set of accounts ). But it is likely that there will be some differences because of different purposes and different groups of stakeholders dominating the information requirements. 2 The European Commission recently issued a Call for Technical Advice (No. 1) from the Interim Working Committee on Financial Conglomerates (IWCFC) on sectoral rules on eligible capital and analysis of the consequences for supervision of financial conglomerates (cf. requestsforadvice/ecletterandcallforadvicecapital.pdf).

9 Introduction 7 Criteria used in determining own funds should not penalise arbitrarily any legal form of insurance companies. No discrimination of mutuals Though, in general, we welcome the European Commission s proposal for a framework directive (published in July 2007) 3 we criticize the system proposed for categorising and limiting own funds. This paper outlines the key positions of the German insurance industry on own funds under Solvency II which should be reflected in the Solvency II framework directive (level 1) and its implementation measures (level 2). 1. Choosing the total balance sheet approach as guiding principle in determining own funds Key positions 2. Recognising surplus funds as own funds of the highest quality without any restrictions 3. Assessing the quality of capital items in an economic manner 4. Taking into account the interaction of own funds and the supervisory ladder of intervention 5. Aligning banking and insurance rules 6. Not including additional prudence outside of capital requirements 7. Allowing group support to replace own funds on solo level 8. Assessing hybrid capital elements economically 9. Accepting the special model of funding mutuals (supplementary members call) 10. Aiming at a harmonization of accounting and Solvency II 3 Cf. EC [2007], EC [2007], Proposal for a directive of the European Parliament and of the Council on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II), Brussels 2007.

10 8 Introduction As overarching principle the German insurance industry pleads for an economic approach in assessing eligible own funds. We are convinced that the best way to be chosen to achieve this objective is the total balance sheet approach as outlined in chapter 1. As a consequence this approach would imply the full recognition of risk buffers like surplus funds and valuation differences (chapter 2) and no arbitrary categorization and limitation (tier system) would be necessary (chapter 3). The other key positions (chapter 4 10) follow the general positions and make them more concrete as regard different dimensions of determining own funds. Solo and local GAAP perspective Unless otherwise stated, we follow a solo entity perspective and not a group view (which would implicate consolidated accounts). As a consequence we refer principally to individual local GAAP financial statements as regards accounting or a solvency balance sheet for a single company.

11 Total balance sheet approach 9 1 Choosing the total balance sheet approach as guiding principle in determining own funds The German insurance industry strongly supports the total balance sheet approach as a basis for the Solvency II framework. 4 According to the total balance sheet approach the available capital is calculated by subtracting the market (consistent) value of the liabilities from the market value of the assets in a (simplified) solvency balance sheet (see Fig. 1). This residual, the available capital, should be eligible to cover capital requirements (own funds). Assets and liabilities should be valued at their market value. If no market value of assets or liabilities exists ( non-hedgeable in CEIOPS terminology), they should be valued at a marketconsistent value which has to be specified in the context of solvency. An alignment in defining market (consistent) values is desirable (see 10.). 5 Although aiming to create a single set of accounts it is likely that the solvency balance sheet will differ to some extent from an accounting balance sheet in amounts and structure (see Fig. 1). The solvency balance sheet should be based on the policyholder s perspective (unlike international accounting where the shareholder/investor is focussed). The approach used in defining own funds depends on the definition of the solvency capital requirement (SCR) or the minimum capital requirement (MCR) respectively. It is an issue of calibration if own funds at the level of the SCR (or MCR) ensure a certain level of confidence. Each liability not included in the ruin definition would be treated principally as available capital by the total balance sheet approach. In its draft framework directive on Solvency II the European Commission (EC) proposes to calibrate all quantifiable risks at 99.5% VaR on a one-year time horizon. Therefore, own funds have to reflect the envisaged role of capital in Solvency II as a buffer against unexpected losses on a relatively short-term horizon. Total balance sheet approach Valuation rules based on the concept of market consistency Solvency vs. accounting Available capital linked with required capital and vice versa One-year time horizon 4 See CEA [2007], CEA Working Paper on the Total Balance Sheet Approach. 5 Care has to be taken in the terminology: The same terms should not be used if the content differs (marketconsistent valuation under Solvency II vs. current exit value vs. fair value).

12 10 Total balance sheet approach (accounting) (accoun- assets (e. ting) g. at amortised assets costs) equity nonequity own available funds (available capital capital) (supervisory) liabilities (supervisory) assets (market values) own funds, not equity accounting balance sheet solvency balance sheet Fig. 1: Simplified balance sheets (both for a solo entity): accounting (local GAAP) vs. solvency view differences in amounts and structure, e.g. equity own funds Assessing capital quality in pillar II Taking into account revaluation differences No tax reduction necessary The adequacy of capital management should be subject of qualitative pillar II requirements. An internal risk and solvency assessment should be forward-looking and might be based on suitable stress tests designed to assess if the regulatory solvency requirements are met on an ongoing basis. However, in the long run the ability to raise capital in the future to meet future capital needs should be taken into account in such a process if this is a reasonable assumption. The total balance sheet approach as an economic approach ensures that all available risk buffers are considered as own funds. This would include surplus funds (see 2.) and any differences in the valuation of assets and liabilities resulting from (local GAAP) accounting vs. solvency principles as available capital. On top of that, capital items which result from an accounting perspective and which serve as risk buffers against fluctuations within the portfolio and over time would fall in this category (risk mitigation on a collective basis and over time). QIS3 suggests that appropriate allowance should be made for potential future tax liabilities associated with the move to a market-consistent value of assets and liabilities. 6 This reflects the expectation that some tax will be payable in the future under normal operating circumstances for the company. However, Solvency II focuses on stressed circumstances and in such conditions the profits expected in normal conditions may 6 See and CEIOPS [2007], QIS3 - Technical Specifications (Part I: Instructions).

13 Total balance sheet approach 11 not arise. If this is the case then the associated tax liability could be significantly reduced or even regarded as zero. In general, the effect of taxation on the funds resulting from differences in valuation should be of minor relevance. Contrary to the accounting concept of going concern, solvency rules focus on the extreme case of bankruptcy/insolvency. In this event, it is unlikely that the generation of funds out of these reserves will lead to a tax impact. Treating tax assets and liabilities in a consistent manner could also lead to an offset. Furthermore, the differences in national tax regimes would create intransparency and be an obstacle to a level playing field and a Single Market. Determining a (national) percentage to deduct tax effects on valuation reserves seems quite difficult as regard national tax legislation which is not based on a solvency balance sheet (conclusions from (effective) tax rates cannot be drawn). The total balance sheet approach is neutral with respect to the application of a particular accounting regime. A categorization and limitation system would reintroduce effects of national accounting standards in determining eligible capital (see 3.). The CEIOPS idea of limiting the amount of eligible elements to quantitative thresholds that are not economically justified (see 3.) is contrary to this systematic approach. As long as quantitative limits cannot be methodologically justified, they are arbitrary and intransparent and create wrong incentives for Solvency II. The result could be that the business model is not appropriately reflected. Tax adjustments refer back to national law Economic view vs. local GAAP view No arbitrary limits The German insurance industry strongly supports the total balance sheet approach: the excess of assets and liabilities at their market values should count fully as own funds.

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15 Recognising surplus funds as own funds 13 2 Recognising surplus funds as own funds of the highest quality without any restrictions The surplus funds are a core element of a product-specific business model of life (and health) insurance which is dominant in Germany. Such life insurance contracts are characterized by high guarantees and many options. To fulfil their obligations, life insurers can build up buffers called surplus funds. 7 As long as the surplus funds are not allocated yet to the individual policyholder, they can serve as a risk buffer (see Fig. 2). In this sense they are not a (solvency) liability though being realised profits appearing in the accounting balance sheet as non-equity items. It follows that assuming the total balance sheet approach the surplus funds have to be counted fully as own funds. Surplus funds = verfügbare RfB as part of own funds realised profits appearing in the accounting balance sheet as non-equity items realised profits which are assigned individually to policyholders surplus fund Fig. 2: Surplus funds as part of realised profits appearing in the accounting balance sheet as non-equity items Surplus funds fully meet the criteria as risk buffer within a riskbased solvency system: Subordination: Surplus funds have to be classified as own funds with their full amount, as repayments to this item of the balance sheet are ranking after all contributions to be made in order to meet liabilities towards policyholders. Surplus funds meet fully the criteria of a risk buffer within a risk-based system 7 German: verfügbare RfB = freie RfB + Schlussüberschussanteilfonds (life) or ungebundene RfB (health).

16 14 Recognising surplus funds as own funds Loss-absorbency: German supervisory law permits that surplus funds are used in order to absorb losses both on a going concern basis and in the case of winding-up. Permanence: The surplus fund is permanently available. Though the amount is breathing by inflows and outflows, its use is subject to the discretion of the undertaking s managing board. No policyholder may specify a claim on this amount. Perpetuality: Surplus funds are not dated. Absence of mandatory servicing costs: The surplus fund has no fixed costs, as in contrast to hybrid capital it does not require any payment of interest or dividends to anyone. In addition, there is no right to redeem the nominal value. Surplus funds under Solvency I Classify surplus funds as tier 1 capital if a tier structure was introduced Significance of surplus funds in Germany Taking into account the results of QIS Due to their risk-absorbing nature surplus funds have already been recognised under Solvency I as risk buffer (2002/83/EC, Article 27 d). It would be astonishing if a risk-based system such as aimed at by Solvency II did not allow for recognition of surplus funds as own funds but allowed for valuation reserves and (complex) innovative instruments. If a tier structure was introduced it would be absolutely necessary to classify surplus funds explicitly as tier 1 capital in order to take account of the risk-absorbing ability of surplus funds. It would not be appropriate to limit their recognition in amount because they have the ability to cover general losses without any credit risk. As paid-up capital and considering their quality characteristics as outlined above, surplus funds are not comparable with tier 2/tier 3 capital items proposed in QIS3. German life insurance companies hold total own funds of about 50 billion. Thereof 42 billion (more than 80%) are surplus funds and only 8 billion (20%) consist of other capital items, mainly equity items. Therefore, the recognition of surplus funds as own funds of the highest quality (tier 1) is essential for the business model of German life insurers. QIS1 and QIS2 have clearly shown the need for an inclusion of surplus funds in the eligible capital. Otherwise many German life insurers would not fulfil the capital requirements under Solvency II (MCR and SCR). In QIS3 surplus funds are

17 Recognising surplus funds as own funds 15 classified as tier 1 capital and so the German results of QIS3 would not be meaningful for a supervisory system which does not recognise properly any risk buffer, especially surplus funds. In addition to accepting surplus funds as risk buffer which increase own funds, the full recognition of the risk absorbing effect of future profit sharing is a key aspect in assessing the solvency coverage ratio (available capital / required capital) of an insurance company as well. Risk transfer by future profit sharing Surplus funds have to be recognised as own funds of the highest quality without restrictions. The productspecific business model of life (and health) insurance with its resulting true-risk profile which is dominant in Germany needs to be mirrored appropriately in the supervisory rules.

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19 Assessing the quality of capital items in an economic manner 17 3 Assessing the quality of capital items in an economic manner In a risk-based approach such as Solvency II, the classification of own funds should also be risk-orientated to be consistent with risk-based capital requirements. Relevant risks in this regard are: credit default or termination. The approach discussed by CEIOPS of cutting own funds into tiers with different thresholds does not seem appropriate to reflect this economic principle. There is no economic rule or empirical evidence that a greater amount of e.g. subordinated loans have a higher credit default risk than a smaller quantity. Therefore, a threshold for these funds being defined as a percentage of tier 1 capital does not seem economically sound. In general, it might be justified to use certain criteria like subordination, loss-absorbency, perpetuality, absence of requirements or incentives to redeem the nominal sum, and absence of mandatory servicing costs to assess if the quality of individual capital items is appropriate to be classified as own funds. But it seems difficult to draw conclusions from them to describe the inherent risks of capital items. With respect to the risk of termination (i.e. for subordinated loans or other forms of hybrid capital), it is understandable that own funds should have a certain permanence. On the other hand, Solvency II is built on a one-year perspective. A longer-term view, which is certainly sensible from a managerial perspective, should be limited to the internal risk control. Therefore, the risk of termination can be treated as being irrelevant in the context of solvency. Qualitative requirements in Pillar II like the own risk and solvency assessment (ORSA) might be justified to ensure the overall quality of capital, but we do not think that arbitrary limitations are appropriate to provide a desired level of prudence in the overall quality of capital (needed to cover capital requirements). We do not believe that a concept of categoriza- Reflecting risk in capital items Credit risk Assessing capital items principle-based Termination risk Capital management Pillar II issue

20 18 Assessing the quality of capital items in an economic manner tion and limitation like that put up for discussion by CEIOPS 8 (Fig. 3) which have to be considered as being interrelated is an adequate approach to ensuring the capital quality to cover capital requirements (SCR and MCR). Economically justified limits in the case of special capital items would need further consideration such as on criteria for their classification. For example if capital items are subject to a default risk the assessment of the eligibility of the amount of these items could take into account a reliable quantifiable counterparty risk. assets (market consistent valuation) available capital liabilities (solvency technical provisions and other liabilities) categorisation tier 3 tier 2 tier 1 limits tier 3 tier 2 tier 1 required capital eligible capital elements to cover: SCR MCR Fig. 3: Total balance sheet approach vs. concept of categorization and limitation of own funds it might happen that artificial limitations on the tiers reduce the available capital to an amount below the SCR although the originally available capital would be sufficient Solvency I with its limitations cannot be the starting point of a limitation system under Solvency II because of the fundamental changes in the calculation of capital requirements. A new limitation system under Solvency II if any should be as simple as possible. We do not believe in general that a complex limitation system will make (arbitrary) limits more appropriate. For instance a double categorization both into basic and ancillary own funds and into tiers is not helpful. On top, it would be not feasible. 8 Cf. CEIOPS [2006], Answers to the European Commission on the third wave of Calls for Advice in the framework of the Solvency II project (CEIOPS-DOC-03/06), Eligible elements to cover the capital requirements (Call for Advice 19), pp A CEIOPS consultation paper contained an extended proposal but the final document submitted to the European Commission contained no advice as regard a categorisation and limitation system. Cf. CEIOPS [2006], Consultation paper 20: Draft Advice to the European Commission in the Framework of the Solvency II project on Pillar I issues further advice respectively CEIOPS [2006], Advice to the European Commission in the Framework of the Solvency II project on Pillar I issues further advice.

21 Assessing the quality of capital items in an economic manner 19 A limitation system if any has to be tested before it is introduced. Much care has to be taken in developing a feasible categorization and limitation system. QIS3 might help to understand the current structure of capital (as influenced by Solvency I regulation) though the guidance provided is very broad. Feedback qualitative and quantitative should be taken into account in doing further work on this issue. But it might not be appropriate to conclude from the current capital to the future (desired) capital allocation. Any principle-based categorization of capital into tiers has to be subject to harmonisation procedures to ensure consistent application of supervisory rules across companies, jurisdictions and over time. In setting limits if any group aspects have to be taken into account. For example restricting group support (tier 2 or tier 3 limits) on solo entity level would hamper the declaration of group support (see 7.). Such general restrictions at tier level would ignore the quality of declared group support. Group support could imply a downgrading of tier 1 capital on holding level to tier 3 capital on solo level though assessed as tier 1 capital as regards the group solvency (covering of the group- SCR). We think that most capital items will not need prior supervisory approval. Harmonisation in supervisory approval across Europe is required if, however, approval seems still necessary in special cases. Testing a limitation system Harmonization Consider group support Normally no need for supervisory approval In the case that restrictions have to be applied though we do no think so it might be acceptable that the MCR should be covered with capital of higher quality than the SCR. Such restrictions in the use of capital for MCR purposes have to be based on clear criteria and should not interfere with the supervisory ladder of intervention (see 4.). In the context of a tier system with limits (if any) so-called innovative instruments and supplementary members calls of mutuals or mutual-type associations have to be considered to ensure their full recognition. Although according to the total balance sheet approach no special treatment of them would be necessary, we will discuss them in the following (see 8./9.)

22 20 Assessing the quality of capital items in an economic manner The German insurance industry is against arbitrary limits on own funds as regards a tier structure and favours an economic assessment of the quality of capital items.

23 Supervisory ladder of intervention 21 4 Taking into account the interaction of own funds and the supervisory ladder of intervention A sound ladder of intervention requires that always MCR < SCR. Sufficient available owns funds to cover the SCR should always be sufficient to cover the MCR, too. There needs to be a sufficient gap between the MCR and the SCR in order to allow a sound ladder of supervisory actions. A total balance sheet approach and a compact MCR as percentage of the SCR (as favoured by the European insurance industry) would not cause any of the mentioned problems. But an arbitrary categorization and limitation system could do so. It should not be forgotten that besides the MCR there is another buffer available on top of the best estimate technical provisions the risk margin, so that the overall aim of the MCR (enabling the transfer to a solvent third party) could be reached when taking into account both buffers. So a compact MCR would be sufficient in the overall context. For example restrictions on the use of capital as cover for the MCR (e.g. no allowance for tier 3 capital) would complicate the application of the supervisory ladder of intervention. MCR < SCR Best estimate liability + risk margin SCR = soft target Non-compliance with capital requirements should trigger supervisory action depending on the degree of non-compliance. In general, a breach of the SCR, i.e. own funds falling below the amount necessary to cover the SCR, is not as material as a breach of the MCR. The SCR should be a soft target which means that from time to time within one year due to some fluctuations a company might dip below the SCR. The consequences of non-compliance with the SCR should not be the same as of non-compliance with the MCR. The negative impacts of an arbitrary categorization and limitation system of own funds on a sound ladder of intervention have to be avoided. The German insurance industry supports the total balance sheet approach and the compact MCR (= x % SCR) which would not give rise to such problems with regard to the supervisory ladder of intervention.

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25 Aligning banking and insurance rules 23 5 Aligning banking and insurance rules The German insurance industry recognises that own funds are also a cross-sectoral issue and supports the aim of harmonisation of banking and insurance provisions to ensure a level playing field and foster a single market for financial services (especially financial conglomerates). 9 Convergence is supported, but not at the cost of inappropriate solvency rules. Where the principles are economically justified and adequate for insurance, an alignment of banking and insurance principles might start with Solvency II and reviewing sectoral rules on eligible capital in the banking/securities sector. If capital instruments are eligible for banks they should also be eligible for insurance companies to ensure a level playing field (equal treatment of equal capital instruments). However, the banking rules should not just be copied. For instance certain prudential filters currently applied in the banking regulations on unrealised gain/loss would not be appropriate under Solvency II. While all risks of insurance companies will be captured in a holistic way under Solvency II in capital requirements, this is not the case for risks of credit institutions under the Capital Requirements Directive (CRD, 2006/48/EC). Further work is needed on the elaboration of the approach on (eligible) own funds considering also the cross-sector dimension with banking supervision to achieve an appropriate harmonised framework. 10 Future developments both in the banking and the insurance sector have to be anticipated and have to be taken into account as regards own funds. Therefore, a joint approach to definition of eligible elements between banks and insurance companies is considered to be appropriate. Harmonisation of the European market for financial services Aligning rules if appropriate Assuring a level playing field Anticipating future developments The German insurance industry pleads for an alignment of insurance and banking rules on own funds if convergence reflects an economic view and ensures a level playing field. 9 The Financial Conglomerates Directive (FCD) requires competent authorities to supervise the capital adequacy of financial conglomerates (Directive 2002/87/EC, Art. 6). 10 Cf. CEBS/CEIOPS [2007], Comparison of the sectoral rules for the eligibility of capital instruments into regulatory capital.

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27 No additional prudence 25 6 Not including additional prudence outside of capital requirements In general, we are strongly opposed to layers of additional prudence being built into various levels not captured by capital requirements if they are not founded on rational economic arguments and do not provide the transparent and calibrated overall solvency criteria we support. Therefore, we strongly disagree with additional prudence in determining own funds by abandoning market valuation. There is no need to add prudence in calculating the best estimate of technical provisions and not to rely on the expected value of (discounted) cash flows which reflects their probability distribution estimated by means of reliable data. Otherwise risks might be counted twice (in capital requirements and in the solvency balance sheet). It seems much more appropriate to integrate risks within the calculation of capital requirements. In addition, intangibles shown in statutory annual accounts should not be deducted from own funds if they are valued economically (i.e. at their market value) like a goodwill under IFRS which is subject to an impairment test every year. No additional prudence Best estimate reflects probabilities of cash flows No reduction for intangibles Additional prudence is not necessary since market values of assets and liabilities include these risks. Then, adequate protection of policyholders requires only sufficient capital on top of (covered) technical provisions. Prudence should be reflected in the capital requirements and not in the calculation of own funds else there would be the danger of double counting.

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29 Allowing group support to replace own funds on solo level 27 7 Allowing group support to replace own funds on solo level The capital requirements for a group will be lower than the sum of those for the legal entities as a result of diversification effects. 11 Diversification is likely because at group level different risks could offset each other if not fully correlated. These effects arise for example because of different geographic areas of insured values or different segments of insurance. In general, they are material and are one of the main reasons for the existence of insurance groups. Group diversification benefits should be down streamed to the solo entities in the form of so-called group support. 12 This increases the available capital at solo entity level if the declaration of a capital transfer is called. A legally binding declaration of group support that meets supervisory criteria should be considered equivalent to own funds at solo level. The declaration of group support in a group should not be restricted arbitrarily in covering the solo SCR. It s eligibility on solo level should not be restricted by defining group support generally as ancillary own funds or as regularly of lower quality than tier 1 capital. We agree that the solo-mcr should be covered by capital within the legal entity but any additional capital locked in at solo level is not justified. Diversification effects exist and are material Down streaming diversification effects No inappropriate restrictions on group support Although the declaration of group support should be of course enforceable supervisory authorities should not be allowed to require guarantees of third parties. Group support should be treated as own funds on solo level without arbitrary restrictions. 11 Cf. GDV [2007], Concept for cooperative group supervision Key statements on group supervision under Solvency II. 12 The European Commission proposed such an approach in its draft Framework Directive (A ). In the context of own funds CEIOPS discussed such an approach as form of contingent capital (cf. CP20, 4.70).

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31 Hybrid capital 29 8 Assessing hybrid capital elements economically Assuming a broad sense of hybrid capital as capital items with certain features of equity (e.g. subordinated debts/innovative instruments), hybrid capital needs to be assessed economically in determining eligible own funds. Profit participation rights ( Genussrechtskapital ) and subordinated debts/subordinated loan capital ( nachrangige Verbindlichkeiten ) have been used by German insurance companies in the past much less in an active way than other equity items in the balance sheet. But in recent years we have observed an increasing use of them in raising capital. In addition these mentioned instruments could be of (potential) high relevance for some companies although being not as relevant for the whole German market. Such instruments present a higher flexibility than ordinary shares. They can also be issued by companies which have no or limited access to capital markets (e.g. mutual insurance companies) or by companies which have foreign subsidiaries in order to improve the congruence between their assets and their capital. Hybrid capital could qualify for regulatory purposes as own funds, but at lower cost than genuine equity. Therefore, these instruments are used, for example, by insurers in order to optimize their capital structure thus reducing their cost of capital. As active capital management is of utmost importance for insurance companies, the relevance of these instruments will increase further in the future. To ensure an equal use of hybrid capital across the different legal environments in Europe we strongly recommend using a broad definition of hybrid capital not referring to legal formats of eligible elements. As a general remark we would like to point out that the inflexibility of the current rules may have prevented the use of certain capital instruments and that therefore the relevance of them today cannot be extrapolated in the future. In particular it seems very difficult to estimate the fungibility of eligible elements in (general) stressed situations. But we think that full economic recognition of these instruments is indispensable under Solvency II a limitation system based on percentages will not fulfil this (see 3.). Broad sense of hybrid capital Advantages of hybrid capital vs. equity Restricted use today should not be guiding for the future

32 30 Hybrid capital Flexibility in the design, as an essential prerequisite of adequate capital instruments, must be of course accompanied by broad limits based on economic risk-based criteria - if any. The German insurance industry recommends both; otherwise competitiveness would be again restrained in an unreasonable manner. For example, regulatory provisions that are too specific will lead to an over structuring (too complex structure) which is counterproductive to transparency demanded by investors. Popular capital instruments Establishing a level playing field for all legal forms Treatment of hybrid capital is important Some instruments for equity recognition (e.g. for rating purposes) have become popular and are often used by insurers. Investors are familiar with most features because they are similar to established instruments in the banking sector. Therefore volumes and pricing can be attractive for insurers if instruments do not include too many other features which might reduce these advantages. Furthermore, hybrid capital is one way of establishing a level playing field for all legal forms of insurance companies: 13 Whereas stock companies have access to capital on the stock market, mutual companies or cooperatives have to raise hybrid forms of capital in case of a need for external sources of financing. The (non-)categorization and (non-)limitation of capital items will be a key determinant in the final impact of the new framework (see 5.). For example, the Solvency II framework would look very different if not 100% of the risk-absorbing effect of subordinated debts counted as eligible. Hybrid capital needs to be assessed economically. If it is risk-absorbing it has to be qualified as non-liability in a solvency sheet (regardless of accounting rules) and the total balance sheet approach would imply that hybrid capital would count as own funds without restrictions in amount and structure. 13 It would also establish a level playing field as regard banks (see 5.).

33 Supplementary members call 31 9 Accepting the special model of funding mutuals (supplementary members call) Supplementary members calls are a key concept of mutuals because in a crisis they can refer back to the collective of insured. The risk of additional payments by the policyholders is part of the signed insurance contract and so there is a legally binding duty for the policyholder to satisfy a supplementary members call. Historically, supplementary members calls go back to the concept of self-help: the premium is calculated with a narrower margin as in the case of adverse developments additional calls can be made. 14 This special feature of the mutual business model should be acknowledged by the solvency system. The possibility to make an additional call is somewhat comparable to non-paid up capital for a stock company. Both forms of funding can be put into practice in critical situations for the insurance company. The German insurance industry is in favour of economically based criteria for admission of these calls in eligible elements to cover capital requirements, with a view to enhance harmonisation among Member States. An economic principle-based approach should be taken in determining the eligibility of obligations to make further contributions, e.g. supplementary members calls or non-paid up capital. Where such an item has been paid in or called up, it should be treated as an asset. Assuming the total balance sheet that would increase the available capital in the solvency balance sheet and therewith, the own funds. The recognition of supplementary members calls should be based on consistent criteria in all Member States (no different supervisory treatment across Europe). With the ongoing convergence in financial services, regulators have a responsibility to ensure a level playing field among insurers domiciled in different countries but operating in overlapping markets. With an issue as important as eligible capital there should be as little difference as possible. Mutual specific capital Dealing with adverse developments in a special way Economically based criteria Harmonization across Europe 14 Concerning the use of supplementary members call cf. CEIOPS [2007], Summary of the industry s contribution on the use of innovative instruments & supplementary members calls as eligible elements of capital (CEIOPS P1 15/07), p

34 32 Supplementary members call We are sure that arbitrary rules that limit the eligibility by a percentage do not cover the particularities of supplementary members calls. Supplementary members calls of mutuals are riskabsorbing and replace other capital items. They should count as own funds.

35 Aiming at a harmonization of accounting and Solvency II Aiming at a harmonization of accounting and Solvency II The objective should be a harmonization of accounting and Solvency II: There are clear advantages from being able to utilise the same or similar platforms to derive accounting and regulatory figures ( single set of accounts ). Therefore, the new insurance solvency rules should take account of the ongoing discussion and development of the new international accounting standards for insurance contracts (IFRS Phase 2 project). 15 Non-compatibility with (international) accounting developments in valuation rules would result in unnecessary initial implementation and ongoing administration costs for insurers due to the introduction of the new solvency framework. Despite the primary objective of convergence it is likely that there will be some differences because of different purposes and different groups of stakeholders dominating the information requirements. In some areas there will be clear differences between the approaches adopted or the nature of the components involved in the different frameworks whereas in others it is expected that differences may exist and there could well be scope to minimise or eliminate those differences depending on the particular strategic objectives applicable. As an example of differences in accounting Solvency II nonequity items that fulfil the criteria for own funds have to be mentioned (no solvency liability but accounting liability). But there could also be differences in the valuation. Using scenarios of shocks on debt securities valued at their market value in Solvency II would not be consistent with amortised costs (as allowed by local GAAP or by IFRS in the category held to maturity ). If accounting and solvency rules allow for different methods, it would be helpful to have the possibility to choose at least one method which is accepted in both areas (e.g. the cost of capital approach in determining a risk margin). Aiming at a single set of accounts but differences have to be accepted if justified Example of potential differences Overlapping choice of methods 15 In May 2007 the IASB published a new discussion paper in which it expressed its view on the convergence as follows: To the extent that the same information can meet the common needs of supervisors and other users, it would be desirable for the information reported to supervisors to converge with the information reported in general purpose financial statements. Cf. IASB [2007a], Discussion Paper - Preliminary Views on Insurance Contracts Part 1: Invitation to Comment and main text, p. 19.

36 34 Aiming at a harmonization of accounting and Solvency II Common terminology only if content identical A common terminology for accounting and solvency purposes would be desirable. But it has to be ensured that the same terms are only used when they have identical meaning or refer to equal concepts in accounting and Solvency II. For example the discussed concept market-consistent valuation under Solvency II, a current exit-value approach under IFRS phase 2 und a (general) fair-value concept should not be mixed up. Covering differences by shared words with varying definitions cannot replace a substantial alignment. Accounting and Solvency II should be harmonized ( single set of accounts ). But it has to be recognised that the different purposes make it likely that there will be differences in presentation and valuation.

37 References 35 References CEA [2007], CEA Working Paper on the Total Balance Sheet Approach, Brussels 2007 (Download: CEA [2007], Diversification and Specialisation benefits, draft working paper, Brussels CEA [2007], The Insurance Groups and Solvency II, draft working paper, Brussels CEBS [2007], Quantitative analysis of eligible own funds in the EEA, London 2007 (Download: CEBS/CEIOPS [2007], Comparison of the sectoral rules for the eligibility of capital instruments into regulatory capital (IWCFC-DOC-07/01), Frankfurt/London 2007 (Download: Comparisonofsectoralrulescapitalinstruments.pdf respectively. documents/iwcfc-doc final%20_comparisonofsectoralrulescapitalinstruments.pdf). CEIOPS [2006], Advice to the European Commission in the Framework of the Solvency II project on Pillar I issues further advice, Frankfurt 2006 (Download: CEIOPS-DOC-08-07AdviceonPillarI-Issues-FurtherAdvice.pdf). CEIOPS [2006], Advice to the European Commission on the treatment of deeply subordinated debt (CEIOPS-DOC-01/06), Frankfurt 2006, Download: CEIOPS [2006], Answers to the European Commission on the third wave of Calls for Advice in the framework of the Solvency II project (CEIOPS-DOC-03/06), Eligible elements to cover the capital requirements (Call for Advice 19), Frankfurt 2006 (Download: CEIOPS-DOC-03-06Answerstothirdwave.pdf). CEIOPS [2006], Consultation Paper 20: Draft Advice to the European Commission in the Framework of the Solvency II project on Pillar I issues further advice (CEI- OPS-CP-09/06), Frankfurt 2006 (Download: consultations/consultationpapers/cp20/cp20.pdf). CEIOPS [2006], Questionnaire on eligible elements of capital (CEIOPS-SEC-74/06), Frankfurt 2007 (Download: SEC-74-06QuestionnaireEligibleElemCap.pdf).

38 36 References CEIOPS [2007], QIS3 - Technical Specifications (Part I: Instructions), Frankfurt 2007 (Download: SpecificationsPart1.pdf). CEIOPS [2007], Report on the implementation of the current insurance Directives with regard to the eligible elements to meet the solvency margin (CEIOPS- P1-14/07), Frankfurt 2007 (Download: submissionstotheec/reportonimplementationoftheinsurancedirectiveswithregardto theeligibleelementstomeetthesolvencymargin.pdf). CEIOPS [2007], Summary of the industry s contribution on the use of innovative instruments & supplementary members calls as eligible elements of capital (CEIOPS- P1-15/07), Frankfurt 2007 (Download: publications/submissionstotheec/summaryoftheindustryscontributionontheuseofinnovativeinstrumentsandsupplementarymemberscalls.pdf). EC [2007], Call for Technical Advice (No. 1) from the Interim Working Committee on Financial Conglomerates (IWCFC) on sectoral rules on eligible capital and analysis of the consequences for supervision of financial conglomerates, Brussels 2007 (Download: ECletterandcallforadvicecapital.pdf). EC [2007], Proposal for a directive of the European Parliament and of the Council on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II), Brussels 2007 (Download: insurance/docs/solvency/impactassess/com _en.pdf). GDV [2007], Concept for cooperative group supervision Key statements on group supervision under Solvency II, Berlin 2007 (will be published soon). GDV [2007], Impact Assessment - Results of the Industry Survey on the Impact of Solvency II, Berlin Hartung, T. [2007], Eigenkapitalregulierung bei Versicherungsunternehmen Eine ökonomisch-risikotheoretische Analyse verschiedener Solvabilitätskonzeptionen, Karlsruhe IASB [2007a], Discussion Paper - Preliminary Views on Insurance Contracts Part 1: Invitation to Comment and main text, London 2007 (Download: A1F71F665135/0/InsurancePart1.pdf). IASB [2007b], Discussion Paper - Preliminary Views on Insurance Contracts Part 2: Appendices, London 2007 (Download: 0D4B179F-E9E2-42E1-8B17-7CBD380CDA95/0/InsurancePart2.pdf).