CEIOPS-DOC-03/06. May 2006

Transcription

1 CEIOPS-DOC-03/06 Answers to the European Commission on the third wave of Calls for Advice in the framework of the Solvency II project May 2006 CEIOPS e.v. - Sebastian-Kneipp-Str Frankfurt Germany Tel Fax secretariat@ceiops.org; Website: 1

2 Table of content Introduction...4 Eligible elements to cover the capital requirements (Call for Advice 19)...6 Co-operation between supervisory authorities (Call for Advice 20) Supervisory Reporting and Public Disclosure (Call for Advice 21) Procyclicality (Call for Advice 22) Small undertakings (Call for Advice 23) Annexes Annex A (Call for Advice No. 21) Annex B (Call for Advice No. 22) Annex C (Call for Advice No. 22) Annex D (Call for Advice No. 22) Annex E (Call for Advice No. 22) Annex F (Call for Advice No. 23) Annex G (Call for Advice No. 23)

3 Style convention The following has been adopted for this document: Advice appears in shaded (blue) boxes, headed CEIOPS Advice Extracts from the Calls for Advice appear in unshaded (white) boxes, with text in italics Descriptive headings are used (such as 'Background', 'Explanatory text' etc.) in an attempt to improve the navigability of the answers. 3

4 Introduction 1. The European Commission has requested CEIOPS to advise on the development of a new solvency system to be applied to life insurance undertakings, non-life insurance undertakings and reinsurance undertakings in the EU. 2. The design details of the future prudential system for the supervision of insurance undertakings are set out in the paper MARKT 2509/03. The paper lists the main features of the Solvency II project. The new system should: assess overall solvency; be based on a three-pillar structure, adapted to insurance; build on a more risk-sensitive approach, with incentives for proper risk management; increase harmonisation of quantitative and qualitative supervisory methods; seek more efficient and effective supervision of insurance groups and financial conglomerates; employ Lamfalussy or comitology techniques to adopt/adapt legislation efficiently; ensure consistency between financial sectors; and be developed in parallel with international developments 1, and in particular be compatible with the estimated outcome of the international accounting (IASB) work. 3. The European Commission has laid down their general conditions for consultation in the Amended Framework for Consultation of CEIOPS and other stakeholders on Solvency II 2. 1 E.g., the work of organisations like the International Association of Insurance Supervisors (IAIS), the International Actuarial Association (IAA) and the International Accounting Standards Board (IASB). 2 Available on CEIOPS website 4

5 Third wave of Calls for Advice 4. The specific Calls for Advice (CfA) in the third wave are listed and discussed in Annex 3 (sequel) to Framework for Consultation 3. The Commission Services ask CEIOPS to advise on detailed rules concerning: Eligible Elements to cover the capital requirements (CfA 19); Cooperation between supervisory authorities (CfA 20); Supervisory reporting and public disclosure (CfA 21); Procyclicality (CfA 22); and Small undertakings (CfA 23). 5. The Commission Services ask CEIOPS to incorporate in the answers, as far as possible, the criteria of the IAIS Insurance Core Principles and to make them operational. 6. CEIOPS has set out its answers in three parts. The first part outlines the specific questions raised in each CfA. The second part provides some additional explanatory information and context. It is intended to describe the rationale and facilitate understanding of the advice. The explanatory text (and the Framework for Answers) does not have the status of advice. The advice itself is marked in blue. This structure was also applied in CEIOPS Answers to the European Commission on the first and the second wave of Calls for Advice in the framework of the Solvency II project 4. CEIOPS notes that it is also broadly consistent with the approach adopted by CESR and CEBS. 10. CEIOPS uses the term 'insurance undertaking' to include direct insurance undertakings and reinsurance undertakings, both life and non-life. However, the specificities of different types of insurance business are reflected in the answers where appropriate. 11. CEIOPS refers to its Framework for Answers in its Answers to the European Commission on the first and the second wave of Calls for Advice. The framework outlines a number of general principles applicable to CEIOPS answers. 3 Available on CEIOPS website 4 CEIOPS-DOC-03/05 and CEIOPS-DOC-07/05, available at CEIOPS website: 5

6 Call for Advice No. 19 Eligible elements to cover the capital requirements Extract from the Call for Advice: The Commission Services request CEIOPS to advise on the elements eligible to cover the SCR and MCR. In its advice, at least the following areas should be addressed: Elements which do not fit with the use of IASB-compatible accounts; new developments in financial instruments; whether different elements should be eligible to cover the MCR compared with the SCR; adjustments necessary to take account of groups; and whether insurance and banking rules should be brought into line. Explanatory text 19.1 Solvency II includes the need to reconsider the list of elements eligible for covering the capital requirements of insurers (on both a solo and group basis) to take into account the new supervisory requirements of the Solvency II-system (Minimum Capital Requirement/MCR and Solvency Capital Requirement/SCR), compatibility with IASB, IAIS, when relevant, consideration of the outputs of the Groupe Consultatif Actuariel Européen/IAA and Basel II, and financial market developments The primary purpose of capital is to act as a safeguard for policyholders and as a cushion against unexpected losses. This should be the fundamental starting point in assessing eligible capital. In addition, insurance liabilities often span a very considerable period of time and capital should enable insurance liabilities to be met even if the insurer is unable to continue in business When assessing eligible capital, consideration of the basis on which the capital requirements are formulated is necessary in order to achieve an overall coherent solvency regime. The regulatory regime, and the solvency assessment as part thereof, should be based on a thorough analysis of the risks to which an insurer may be exposed. The 6

7 characteristics of these risks should coherently drive the view, on inter alia, the required and available capital, including valuation issues Besides securing an appropriate level of policyholder protection, reducing the scope for regulatory arbitrage and promoting a level playing field within and between the financial sectors are fundamental objectives in the process of modifying the definition of eligible capital elements. This is relevant in the context of insurance groups, and particularly financial conglomerates, as well as on a solo basis. The definition of eligible capital should not create unnecessary barriers to entry for insurance undertakings wishing to join the insurance market Although different types of entities such as insurers, banks and investment firms have different risk profiles, capital and its function as a buffer is, to a large extent, a uniform concept in supervision across all the financial sectors. Further, although the existing sector specific supervisory regimes are generally based on separately developed frameworks, the definition of eligible capital elements is already fairly well aligned across the sectors Basel II and the re-cast Capital Requirements Directive (CRD) made only minor amendments to the definition of eligible capital for the banking and investment firm sectors. 5 However, there is a firm commitment in Basel and the EU to a fundamental review of the definition of own funds (the Own Funds Review "OFR"). 6 This OFR is expected to lead to changes in the definition of eligible capital for banks and investment firms. It is therefore fundamental to the objective of reducing regulatory arbitrage and promoting a level playing field that communication between the sectors is established and maintained, particularly as the timetable for the OFR is later than that established for the review of eligible capital under Solvency II. However, cases of arbitrage between the two sectors have not been seen frequently to date The IAIS has undertaken significant work developing a supervisory standard on suitable forms of capital. This work is expected to be finalised in due course Any proposed modifications to the definition of eligible capital for banks and investment firms as a result of the OFR and for insurers according to the IAIS project, should be taken into consideration in assessing 5 The changes to the definition of own funds in the Basel II framework and re-cast CRD result from the impact of IAS/IFRS on the definition of capital, the introduction of the advanced approaches to calculating credit risk and the new treatments for securitizations. 6 On 24 November 2004, the EU Banking Advisory Committee, now the European Banking Committee (EBC), agreed to undertake a review of the definition of own funds and an EBC working group has been established to conduct this work. In June 2005, the EBC working group sought the technical advice of CEBS on a number of issues see 'Call for Technical Advice (No. 4) from the Committee of European Banking Supervisors (CEBS)'. 7

8 eligible capital for insurers as a part of the Solvency II current and ongoing work. Eligible elements of capital to cover solo requirements Supervisiory approach to capital 19.9 The current common supervisory approach to capital is based on an accounting perspective. This is also the approach which will be maintained in the answer to CfA 19. Under this approach, the balance sheet can be divided between assets on the one side and liabilities/capital on the other. Technical provisions are defined and matching assets established. A number of risks are considered and a capital requirement is produced. Regulation then determines which elements of capital are eligible to meet this requirement In the context of solvency supervision it should be noted that under Solvency II, advanced scenario based concepts may be applied to calculate solvency margin requirements and there will be better recognition of risk mitigations. In addition, the cross-over from capital markets to insurance of transactions such as securitizations, as well as use of reinsurance contracts for financing purposes, means that the traditional boundaries between risk mitigants and capital on an accounting basis are blurring. As a consequence, there is a need for greater consistency of treatment between risk mitigants (which reduce capital requirements) and the recognition of eligible instruments (which increase available capital) to avoid distorting measures of an individual insurer s solvency position In the future, approaches to assessing the eligibility of capital elements, other than from an accounting perspective, should be considered. For example, scenario-based techniques which assess the potential additional risks represented by capital instruments such as: credit risk (e.g. relating to unpaid share capital); legal risk (e.g. with an obligation to repay dated capital instruments at a time when the capital is needed for policyholder protection); and economic risk (e.g. the incentive to make instruments as debt-like as possible to secure favourable tax treatments and which may result in economic pressure to repay capital instruments, or increased costs of capital, at a time of need for policyholder protection. 8

9 19.12 In addition, approaches based on cash flow scenario analyses regarding risks and conditions attached to specific capital instruments may be considered. These alternative approaches are, for the moment, beyond the scope of the Solvency II work, but may be examined at a later stage. Purpose of capital elements Solvency supervision is based on the quantification of risks undertaken by an entity. From a regulatory perspective, the main purpose of capital is as a cushion against unexpected losses. The amount of capital an insurance undertaking holds should therefore enable the entity to absorb significant unforeseen losses over a specified time horizon and to a defined confidence level and should give reasonable assurance to policyholders that payments will be made as they fall due. Requiring insurers to maintain adequate capital also enhances the safety and soundness of the insurance sector and the financial system generally The choice of risk measure used in the solvency assessment and the specific functions of capital from the perspective of insurers and supervisors will influence the perception of the quality of capital. Specifically, eligible capital might be assessed against the extent to which it: reduces the probability of insolvency by absorbing losses on a going concern basis or in run-off; and/or reduces the loss to policyholders in the event of insolvency or wind-up, bearing in mind that each jurisdiction is governed by its own laws regarding insolvency and wind-up. In insolvency, common equity shareholders normally have the lowest priority in any liquidating distribution of assets, immediately following preferred shareholders. In some jurisdictions, insurers can issue subordinated debt that provides protection to policyholders and creditors in insolvency. Policyholders are often given a legal priority above other creditors such as bondholders, whereas other jurisdictions treat policyholders and other creditors equally (especially if the creditors have secured claims) The EU Working Group on Own Funds (WGOF) 7 charged with carrying out the OFR for the banking and investment firm sector states that the fundamental function of capital is to absorb losses of the entity. The WGOF has charged CEBS to elaborate on this view and to consider what fundamental purpose capital should serve. 8 The WGOF has agreed that 7 The EBC (formerly the BAC) Own Funds Working Group. 8 See Call for Advice (No. 4) to CEBS on the review of the definition on own funds. 9

10 a useful approach to assessing the quality of capital is to identify the limitations of any given instrument for loss absorption purposes considering two key features of capital principal and interest and the different life stages of an entity: going concern, financial stress and insolvency In addition to the above, the following general criteria to assess the quality of capital should be considered: permanence and the availability in times of stress; servicing costs/repayment and their potential for deferral or even cancellation in times of stress; subordination or seniority on interest and principal amount; and in the case of contingent capital, such as unpaid share capital and members calls for which the insurer does not receive the funding until a specified event, counterparty creditworthiness. International accounting framework The implementation and impact of different accounting standards should be considered when reviewing the definition of eligible capital. Both local GAAP and IAS/IFRS will be relevant since the Solvency II regime will not require all insurance undertakings in the EU to adopt IAS/IFRS As the current approach to capital is based upon an accounting perspective, the stated capital position may well differ between different reporting standards. If CEIOPS is to work towards minimizing regulatory arbitrage and creating a level playing field, the choice, or application, of the particular accounting regime should be neutral insofar as determining the eligible capital. In addition, the changes in financial reporting criteria resulting from IAS/IFRS should not weaken the supervisory regime in terms of leading to unintended increases (or decreases) in the amount of eligible capital To ensure that the calculation of eligible supervisory capital is both independent from the choice of an accounting regime and is consistent with what the supervisory regime is aiming to achieve, a common reference standard should be determined and necessary adjustments, 9 The Amended Framework for Consultation on Solvency II European Commission Consultation paper July 2005 states as follows: Presently, only EU listed insurance companies are required to present consolidated financial statements according to endorsed IAS/IFRS, although Member States may broaden the field of application. 10

11 or "prudential filters", to the accounting capital established to achieve this standard A number of prudential filters were considered in respect of the Basel banking accord (but have not been formally included in the Basel II framework), and the re-cast CRD included prudential filters, relating to the treatment of: gains/losses on the valuation of own financial liabilities due to the deterioration of the entity's own creditworthiness; and unrealized gains and losses on cash flow hedge transactions The prudential filters for the insurance sector and those applicable to the banking regime should, where appropriate, be aligned and be subject to further changes which may result from the commitment to revisit the issue of prudential filters in the near future Potential prudential filters considered as part of the Solvency II regime should, among others, relate to: the valuation of technical provisions, bearing in mind this valuation issue will not be specifically addressed by the IASB until it has finalized Phase II of its "Insurance Contracts" project; the valuation of assets, bearing in mind that their valuation under IFRS may lead to undesired results between what the accounting and supervisory frameworks are aiming to achieve; the recognition and valuation of the participating fund surplus (which plays a major role in some jurisdictions) under different accounting frameworks and bearing in mind this will be dealt with under the IASB's Phase II project; varieties of innovative assets; some intangibles, such as goodwill 11 ; unrealized gains and losses and their associated tax liabilities, and other relevant realization expenses; taxes recoverable and any future tax benefits if such recoveries are not readily available in a winding up; and equalization reserves and catastrophe provisions, i.e. amounts set aside on the balance sheet in compliance with legal or 10 See CEIOPS Recommendation regarding the Implications of IAS/IFRS Introduction for the Prudential Supervision of Insurance Undertakings, published on CEIOPS website at 11 Further work is required to establish which intangibles would need to be deducted and why. 11

12 administrative requirements to equalize fluctuations in loss ratios in future years or to provide for special risks Regarding the reference standard for the valuation of assets, there are two obvious alternatives, namely valuation according to IFRS standards and overall valuation at market value The issue with using IFRS as a basis for asset valuations is that IFRS contains options for the accounting of particular assets (e.g. held-tomaturity bonds ), and also IFRS may not be required for all insurance undertakings in the EU. Moreover, with regards to assets, CEIOPS has taken the view, as a working hypothesis, that assets should generally be accounted for at their market value for the SCR calculation. 12 Consequently, the valuation of assets at their market value should be taken as the reference standard For technical provisions, CEIOPS has noted that their valuation for the purposes of calculating the SCR should be compatible with the rules on the calculation of the technical provisions to be developed as part of the future solvency framework. 13 Thus, these rules will provide a possible definition of the reference standard for the valuation of technical provisions In relation to assets and technical provision, depending on the accounting framework applicable (local GAAP/IFRS), hidden reserves or deficits may arise when: market values of assets differ from their statutory/accounting values; or a difference occurs in the statutory/accounting valuation of technical provisions and their valuation in the context of the future solvency framework. The recognition of these hidden reserves or deficits provides a means of reconciling statutory accounts with the market consistent "simplified balance sheet" concept underlying the SCR calculations The application of prudential filters may lead to decreases or increases in the amount of an insurer s eligible capital. Consideration should be 12 Cf. para in CEIOPS' Answers to the European Commission on the second wave of Calls for Advice (CEIOPS-DOC-07/05 available on CEIOPS website: 13 Cf. para in CEIOPS' Answers to the European Commission on the second wave of Calls for Advice (CEIOPS-DOC-07/05 available on CEIOPS website: See Answers to CfAs 7 and 8 in CEIOPS' Answers to the European Commission on the second wave of Calls for Advice (CEIOPS-DOC-07/05 available on CEIOPS website: Cf. para in CEIOPS' Answers to the European Commission on the second wave of Calls for Advice (CEIOPS-DOC-07/05 available on CEIOPS website: 12

13 given as to how each filter is to be applied, e.g. whether it is an adjustment to higher or lower quality capital. The application of the adjustments should however, as a minimum, be consistent with the principles of the 3-tier-approach by categorising eligible capital items according to their quality as described below. Existing Categorizations of capital elements and limitations - The Life and Non-Life Directives The current Directives 16 (the "insurance Directives") split eligible capital elements to meet the solvency margin into three categories. The classification into different categories of eligibility seeks to ensure the quality of an insurer s capital is maintained by offering more favourable treatment to instruments that can provide greater loss absorbency. Article 27 of the Life Directive and Article 16 of the Non-Life Directive set out the eligible capital items and their limits for meeting the solvency margin: elements which may meet the solvency margin without limit including: - paid-up share capital, (common share capital and perpetual non-cumulative preference shares); - reserves (statutory or free) not corresponding to underwriting liabilities and retained earnings; - initial or foundation fund; - subordinated members accounts (meeting specific requirements); - profit reserves (participation fund surplus); supplementary elements which are eligible up to specified limits including: - perpetual cumulative preference share, perpetual cumulative subordinated debt and perpetual securities, limited to 50% of the lesser of the available and the required solvency margin; - fixed-term subordinated debt and fixed-term preference shares, limited to 25% of the lesser of the available and required solvency margin; 16 Recast Life Directive 2002/83/EC and First Council Directive on the taking-up and pursuit of the business of direct insurance other than life assurance 73/239/EEC as amended. 13

14 elements that need the prior approval of the supervisory authority before they can be eligible to meet the solvency margin, including: - no more than 50% of members' calls for non-life mutuals up to 50% of the lesser of the available or required solvency margin; - future profits 17 subject to a limit of 25% of the lesser of the available or required solvency margin; - hidden reserves arising out of the valuation of assets; and - not more than 50% of the unpaid share capital or unpaid initial fund up to 50% of the lesser of the available and required solvency margin. The current Directives also include deductions to capital, i.e. intangible assets, own shares and holdings in other financial institutions (for the last item, see further para ). - Banking regime classifications The relevant banking regime classifications are tier 1, tier 2 and tier 3 capital: tier 1 capital, split into: - core tier 1 capital i.e. paid-up voting common shareholders' equity, disclosed reserves and retained earnings; - non-innovative tier 1 capital e.g. perpetual non-cumulative preference shares; and - innovative tier 1 hybrid capital instruments. The predominant part of a bank's tier 1 capital should be met by core tier 1 capital, which is generally interpreted to mean at least 50% of tier 1, and hybrid capital instruments are eligible tier 1 capital up to 15% of tier 1. tier 2 (supplementary) capital, limited to a maximum of 100% of tier 1 capital, further split into: - upper tier 2 elements, including perpetual subordinated debt and tier 2 hybrid capital; and 17 Under the Recast Life Directive 2002/83/EC (Article 27), future profits will no longer be eligible capital from 31 December 2009 onwards. Future profits do not represent higher quality capital on the basis that in event of a wind-up or run-off, such future income may be reduced. 14

15 - lower tier 2 elements, including dated subordinated debt and dated preference shares which are limited to a maximum of 50% of tier 1. tier 3 capital to meet market risks and which is limited by reference to tier 1. Similarities and differences between financial sectors Although the current insurance Directives and the Basel banking accord 18 together with the banking Directives 19 provide a similar approach to defining and categorizing capital elements based on the extent to which they can absorb losses, there are a number of key differences between the banking and insurance regimes which should be considered if harmonization and promoting a level playing field within and between the financial sectors is to be achieved The key differences in the definitions of eligible capital elements relate to the: recognition of different forms of capital, including contingent capital; required deductions from capital; limits on the eligibility of capital items; and treatment of recent financial innovations Consideration should be given as to whether the differences are both necessary and justified for prudential soundness or sector specific reasons, and as to whether future regulation should be modified to achieve harmonization See Basel Committee publications relating to the existing Capital Accord, Directive relating to the taking up and pursuit of the business of credit institutions 2000/12/EC ("Banking consolidation Directive"). 15

16 - Recognition of different forms of capital, including contingent capital The current insurance Directives recognize a number of capital elements not recognized in the banking Directives or in the Basel banking accord; namely: certain members' accounts; members' calls; participation fund surplus; unpaid share capital or unpaid initial fund; initial or foundation fund; future profits; and zillmerising amounts Subordinated members' accounts, the initial or foundation fund and members' calls for supplementary contributions are specific forms of capital for mutual insurance undertakings and provide a key source of capital for different types of mutual insurance undertaking and for allowing new such mutuals to be established. The definition of, and specific requirements, for such capital items should be considered, bearing in mind the nature of the mutual sector and the extent to which such items may not meet the requirements for permanence and loss absorbency that apply to the non-mutual sector The participation fund surplus is retained earnings attributable to a class of with-profits policyholders and has no exact correlation in the banking Directives. The question of its eligibility as capital is connected with the treatment on policyholders' reasonable expectations of future returns in the assessment of an insurer s liabilities. Those parts of the participating fund surplus which have already been assigned to individual contracts are not eligible as capital, whereas the remaining parts might be taken into account as eligible capital in those cases where, under national law, these amounts may be used to cover general losses In the future solvency regime, the valuation of technical liabilities in life insurance may encompass amounts in respect of future benefits to policyholders. In cases where, under national law, these amounts may be used to cover general losses and have not yet been made available for distributions to policyholders, they may be treated in the same way as the participation fund surplus Zillmerising amounts arise when undertakings include a margin in the valuation of their life contracts. I.e. the amounts are not restricted to covering losses in respect of specific groups of policyholders. 16

17 19.37 Unpaid share capital plays no part in eligible capital under the banking regime. It is a fundamental requirement of the banking Directives that capital is fully paid, since it may otherwise be unavailable to absorb unforeseen losses. In the insurance sector, unpaid share capital is subject to prior approval of the supervision authority, and the proportion of it that is taken into account is dependent on the supervisor's assessment of the counterparty s credit-worthiness and willingness to pay. The recognition of unpaid elements for calculating the available solvency margin is of importance in some Member States and for some types of insurers (for example, mutuals, P&I clubs). This practice should be subject to further consideration, insofar as these elements are appropriate for the safety of policyholder interests. - Required deductions from capital The banking regime requires the deduction of holdings in other financial and credit institutions which exceed certain thresholds relative to the issuer and the holder's capital. The rationale for these deductions is to avoid double gearing and contagion issues within the financial sector. The current insurance Directives, as amended by the Financial Conglomerates Directive (FCD) 22, also address double gearing by requiring a deduction from insurers' capital in respect of participations in other financial institutions (including insurance undertakings, reinsurance undertakings, insurance holding companies, credit and investment firms. This deduction can be avoided by applying an alternative FCD method). According to the exercise of the option provided in the FCD, both in banking and insurance, such deductions might be avoided at solo level provided that the double gearing related to these holdings is dealt with at group level (through consolidated or supplementary supervision, see also para ). - Limits on the eligibility of capital items The rules for limitation of the amount of supplementary capital eligible for regulatory purposes are different in the insurance Directives and the banking regime. In the insurance Directives, the limits are tied to the lesser of the required and the available solvency margin, whereas they are tied to the amount of tier 1 capital in the banking regime In this regard the current insurance Directives may be interpreted so as to be more restrictive than the banking regime on the eligibility of supplementary capital for regulatory purposes if an insurer has surplus capital over its required solvency margin. Alternatively, the insurance Directives could be interpreted as placing limits on eligible capital to meet the regime requirements only. Capital which is surplus to these requirements is beyond the Directive's scope. The banking Directive 22 Directive on the supplementary supervision of credit institutions, insurance undertakings and investment firms in a financial conglomerate, 2002/87/EC ("FCD"). 17

18 does however place the same limits on items eligible for inclusion in own funds, whether this is to meet the minimum requirements or for other purposes for which an own funds total is needed The Basel banking accord requires banks to hold a minimum amount of the highest quality core capital, namely voting common shareholders' equity and retained earnings. This minimum is expressed as requiring such capital to be the "predominant form of a bank's tier 1 capital" 23 which has been generally interpreted to mean at least 50%. The prudential justification is that such core capital allows the bank to conserve resources when under stress by providing the bank with full discretion as to the amount and timing of distributions and having no obligation to repay. In addition, the voting rights attached to common stock are considered to provide an important source of market discipline over a bank's management. - Treatment of recent financial innovations The insurance Directives, unlike the Basel banking accord, have not kept up with the recent financial innovations in hybrid capital capital which has characteristics of both debt and share capital, and which provides cheaper funding than share capital. This has resulted in the banking accord granting a more favourable treatment to hybrid instruments compared to the current insurance Directives Hybrid instruments under banking regulation are classified as innovative capital and are eligible to meet solvency requirements to a greater extent than subordinated debt i.e. they are eligible tier 1 capital up to 15% of tier 1. Such classification is subject to the hybrid instruments providing a minimum level of permanent loss absorbent capital which aims to ensure the quality of a bank's capital is maintained In banking, the characteristics of hybrid capital include: fully-paid and unsecured; perpetual, but features that encourage an issuer to redeem such as moderate step-ups in the coupon rate, after a sufficiently long term and within acceptable limits such that a reasonable level of permanence is achieved, are acceptable (see below); available to the issuer to absorb losses on a going concern basis and well before any serious deterioration in the issuer's financial position; junior to depositors [policyholders], general creditors and subordinated debt holders; 23 Basel Press Release "Instruments eligible for inclusion in tier 1 capital" 27 October

19 discretion over the payment of servicing costs, although features triggering the non-payment of dividends on more junior capital if deferral is exercised are acceptable; and non-cumulative Moderate step-ups are permitted, in conjunction with a call option, only if they occur at a minimum of ten years after the issue date and result in an increase over the initial rate that is no greater than, at national supervisory discretion, either 100 basis points, less the swap spread between the initial index basis and the stepped-up index basis; or 50% of the initial credit spread, less the swap spread between the initial index basis and the stepped-up index basis. The terms of the instrument should provide for no more than one rate step-up over the life of the instrument. The swap spread should be fixed as of the pricing date and reflect the differential in pricing on that date between the initial reference security or rate and the stepped-up reference security or rate. 24 It should be noted, however, that on an average, commitments in insurance are of longer duration than in the banking sector. Since a step-up amounts, in practice, to a fixed-term debt, it might be not advisable, to include such devices in capital eligible elements, notwithstanding their eligibility in the banking sector. Suggested categorization of capital elements The categorization of eligible capital and identification of deductions should be based upon broad principles allowing consideration of innovations of capital and changes in accounting systems and should take into account the particularities of the different jurisdictions. For example, the participation fund surplus, which plays a major role for the available solvency margin under Solvency I in some Member States, should not be excluded from capital The formal classification of capital into "tiers" i.e. tier 1 and upper and lower tier 2, is well established, transparent and consistent with the existing approach in the insurance Directives to categorise elements into distinct levels of eligibility. Further, applying these classifications to insurers' capital would have the advantage of helping to achieve the desired cross-sector consistency. 24 See 19

20 19.48 In assessing the eligibility of such items, supervisors should seek to adopt a convergent approach by developing consistent criteria for eligibility and adopting consistent treatments in terms of classification as a particular tier and applying any relevant limits. - Tier 1: highest quality capital Tier 1 capital should consist of the highest quality capital available. It has to be fully loss absorbent and therefore needs to be currently and permanently available A percentage of eligible tier 1 capital should be met by the highest quality core capital. What constitutes an adequate minimum percentage may depend on the type of insurer, how the requirement interacts with solvency control levels, and in particular, on the MCR calculation (including any embedded floor). A possible approach is to require that at least 50% of tier 1 be met by core tier 1 capital Core tier 1 capital may include the following items: paid-up voting common shareholders equity; retained earnings calculated using the supervisory balance sheet; initial or foundation funds; those parts of the participation fund surplus which have not yet been assigned to the individual contracts (see para ) and may, under national law, be used to cover general losses; and in life insurance, the part of the technical provisions in respect of future benefits to policyholders, provided that under national law these amounts may be used to cover losses and have not yet been made available for distributions to policyholders. Regarding these two last items, it should nevertheless be noted that, since they are in principle, or may be, attributable to withprofits policyholders, it is still to be debated under which circumstances they might be admitted as capital, and if so, whether as tier 1 or tier 2. Further work is envisaged in this area. Non-innovative (tier 1 capital other than core or innovative hybrid tier 1 instruments) may include items such as subordinated members' accounts which provide equivalent loss absorbency as tier 1 share capital of a proprietary insurer and non-cumulative perpetual preference share capital Permitting insurers to classify hybrid capital more favourably which provides a minimum level of permanent loss absorbent capital will help to create a level playing field in the capital markets by allowing insurers to raise economically more efficient capital to meet solvency 20

21 requirements. The eligibility of hybrid capital as a higher quality capital should however be limited. A possible limit is 15% of tier 1 (after adjustments), or by reference to a pre-specified percentage of required capital in cases where this exceeds tier 1 capital. - Tier 2: supplementary elements which are eligible up to specified limits Tier 2 capital consists of capital that lacks some of the characteristics of tier 1 capital, but still provides a certain degree of loss absorbency, either during ongoing operations or during insolvency/winding-up only, including subordination to the rights (and reasonable expectations) of policyholders As tier 2 capital does not provide the same amount of loss absorbency as tier 1, the extent to which it is eligible to meet solvency requirements should be limited according to its ability to absorb losses. The limits should be expressed by reference to the available tier 1 capital or by reference to a pre-specified percentage of the SCR in cases where this exceeds tier 1 capital. With reference to available tier 1 capital, possible suggested limits are 100% of tier 1 for total tier 2 items and only 50% of tier 1 can be met with items classified as lower tier 2. The idea whether the eligibility of capital should, or should not, be primarily dependent on the categories of risks and corresponding characteristics and horizons, needs to be further examined Upper tier 2 capital may include: perpetual cumulative preference shares; perpetual subordinated debt; and hybrid capital not eligible as tier Lower quality tier 2 capital may include: - Tier 3 capital 25 dated subordinated debt; and dated preferred shares Tier 3 capital is capital whose eligibility is subject to the prior approval of the supervisory authority. Items include: zillmerising amounts (Solvency II should ensure that liabilities are valued realistically and therefore this should become unnecessary); and 25 Tier 3-capital for insurers is not comparable with tier 3-capital for banks. 21

22 contingent capital such as potential members' calls by a mutual non-life insurer in principle and the unpaid element of partly-paid equity or foundation fund other contingent capital items such as letters of credit. The approval process would need to be transparent and subject to peer review. Contingent capital as a rule should be considered tier 3 capital, but in limited circumstances the supervisor may reclassify these elements (except partly paid equity) as tier 2 following the approval process. At a minimum the supervisor should then require evidence that: the insurance undertaking had assessed creditworthiness and willingness to pay the capital the capital could be raised within 1 year. CEIOPS will consider objective criteria for determining the circumstances under which such a reclassification could take place Since contingent capital is not paid up and may not be available to absorb losses of the insurer, it should not be taken into full account automatically. It is suggested that the percentage of the contingent capital which is evaluated to be eligible should depend upon the counterparty s credit-worthiness or their ability or willingness to pay Tier 3 capital should be subject to appropriate limits which are applied by reference to the sum of tier 1 and tier 2 capital, or by reference to a pre-specified percentage of the SCR in cases where this exceeds the sum of tier 1 and tier 2 capital. - Adjustments to capital Various adjustments to capital may have to be made with respect to prudential filters to accounting capital deductions (e.g. intangibles) and group-related deductions. The limitations on the different tiers and forms of eligible capital should be imposed after applying the deductions from or additions to capital resulting from prudential filters and other adjustments. Limitations on capital to meet the MCR and the SCR The CEIOPS answer to CfA 15 states that: The MCR reflects a level of capital below which an insurance undertaking s operations present an unacceptable risk to policyholders. 22

23 If an undertaking s available capital falls below the MCR, the ultimate supervisory action should be triggered. 26 In such circumstances, the function of available capital as a buffer for policyholder protection is crucial in the event of a run-off or winding-up The SCR addresses policyholder protection on a going concern, rather than a wind-up basis (working hypothesis is a time horizon of one year) The limitations on capital meeting the MCR and on capital meeting the SCR should be clearly specified. Theoretically, situations may exist where the difference between the MCR and the SCR is rather low. Defining two independent frameworks for capital to be accounted for as eligible capital for meeting the MCR and for meeting the SCR (for instance to allow a 15% basket of hybrid capital in tier 1 capital and / or elements of tier 2 and 3 for meeting the SCR, but to exclude hybrid capital and elements of tiers 2 and 3 from tier 1 when they are accounted for meeting the MCR) could lead to a situation in which the SCR is met, but the MCR is breached due to a lack of quality in the undertaking s capital A more prudent approach might be to define minimum requirements for capital that is used to meet the MCR, and to be somewhat less restrictive on the capital that is used to meet the excess of the SCR over the MCR. Similarly, according to the different aims of the MCR and the SCR, two distinct levels of limitations on the amount of capital of certain quality or type to be accounted for as eligible capital may be considered, corresponding to the major different triggers for supervisory action. However, one would need to be mindful of not creating an unduly complex system What constitutes an adequate form of capital for covering the MCR may depend on the type of business, how the requirement interacts with solvency control levels, and in particular on the MCR calculation Depending on the MCR calculation as well as the definition and the function of the floor to be included in the MCR, further discussion should be envisaged whether the current restrictions on elements eligible to meet the minimum guarantee fund should be maintained for the purposes of meeting the floor to be included in the MCR or the MCR itself. (The current insurance Directives do not allow insurers to meet the minimum guarantee fund with unpaid capital elements or the items listed above which require supervisory consent - other than hidden reserves). 26 See para in CEIOPS' Answers to the European Commission on the second wave of Calls for Advice - CEIOPS-DOC-07/05, available on CEIOPS website: 23

24 Eligible elements of capital to cover group SCR Components of group capital The capital elements eligible to cover the group solvency requirement should be the same as those eligible to cover the solvency requirements at individual entity level except that group capital should be adjusted to eliminate double or multiple gearing, to exclude non-transferable elements of capital in excess of SCR to be in line with both, the Insurance Groups Directive (IGD) 27 and the FCD; and to recognise the group's economic interest in subsidiaries and participations The calculation of available group capital should continue to be based on the current rules set out in the IGD and FCD CEIOPS has expressed in the answer to CfA 18 the view that the primary solvency control at group level should be based on the SCR although a proxy group MCR is also being defined as basis for a potential floor to the group SCR. 28 This group SCR is a level of capital considered adequate to support business on a going concern basis. For this purpose a broader definition of capital than that considered eligible for meeting the MCR might be appropriate, it might include lower quality forms of capital in addition to higher quality capital Consideration of the appropriate proportion of higher quality capital elements relative to lower quality elements will be important in the group context. In that frame, the consolidation method would be considered as the method to be used "by default". However, other methods based on aggregation/deduction principles could be allowed when the consolidation method is not applicable. The two methods may also be mixed if necessary - for example, in the case of companies which are not consolidated but should be included in the solvency assessment At this stage CEIOPS thinks that possible options for setting the proportion of core & non core capital allowed to cover the group SCR include: the sum of the solo MCR of entities belonging to the group ( proxy group MCR) should respect the same rules as regards the capital items eligible and applicable limits as at the solo level (higher and lower quality capital); and 27 Directive on the supplementary supervision of insurance undertakings in an insurance group 98/78/EC (IGD). 28 Please note that the recommendation made in the answer to the CfA 18 is that there should be no group MCR. 24

25 the SCR at group level should respect the same rules as regards the proportion of core & non core capital as at solo level In principle CEIOPS considers that the relative proportions of higher and lower quality capital elements at group level should be set on the same basis as for solo capital elements. Methods used to adjust the solvency of a group for double or multiple gearing, transferability of capital and recognition of the group's interest in subsidiaries and participations Three methods are currently allowed to calculate solvency at group level, which are supposed to be equivalent: a deduction and aggregation method, a requirement deduction method, and an accounting consolidation-based method as well as a combination of these (in FCD) The current IGD states that the Member States shall provide that the calculation of the group solvency shall be carried out according one of the three above-mentioned methods. The Directive however allows the Member States to provide for the competent authorities to authorise or impose the application of one of the three methods other than that chosen by the Member State. 30 In its Report on possible need for Amendments of Insurance Groups Directive, CEIOPS recommends to delete the Requirement Deduction Method from the current IGD as it is not used as a main method in any Member State. If not deleted, it should anyway be amended in order to make it consistent with the similar calculation method envisaged under the FCD In order to ensure flexibility together with a level paying field throughout EU, all the available methods should be set out clearly in the future Directive Practical experience of supplementary supervision of groups shows that some difficulties can be encountered when assessing the capital adequacy of a group. This results, amongst other things, from: the fact that the eligible capital elements to cover solvency requirements at solo level can differ from one Member State to another 32 ; and 29 See annex 1, point 3. of the IGD and annex 1, point II of the FCD. 30 See annex 1, point 1. A of the IGD. 31 Available on CEIOPS website: 32 For example, unrealised capital gains can be considered gross or net of taxes; it currently depends on the Member States. 25