The European Council has approved the Omnibus II Directive (“O2”). With the adoption of O2, the Solvency II framework Directive (2009/138/EC, “S2”) is finally final. This does not mean that all is clear. Further details concerning many subjects still need to be provided in delegated and implementing acts and in guidelines. Yet, we now finally have the definitive text of the framework directive. The text of O2 is expected to be published in May 2014.
The European Council has approved the Omnibus II Directive (“O2“). With the adoption of O2, the Solvency II framework Directive (2009/138/EC, “S2“) is finally final. This does not mean that all is clear. Further details concerning many subjects still need to be provided in delegated and implementing acts and in guidelines. Yet, we now finally have the definitive text of the framework directive. The text of O2 is expected to be published in May 2014.
This legal alert highlights the main changes that O2 makes to S2. Insurers should take these changes into account when preparing for the implementation of S2 as of 1 January 2016. Though we only refer to the position of insurers in this legal alert, the points we address will similarly apply to reinsurers.
We discuss the impact of the Lisbon Treaty and European System of Financial Supervision, the long-term guarantee package, third country equivalence, the transitional measures, and phasing-in of S2. We also note a few other changes that have less of an impact.
1. Lisbon Treaty and European System of Financial Supervision
During the negotiations on O2, the main focus of the insurance sector shifted to the treatment of long-term guarantees under S2 (see 2. Long-term guarantee package). This makes it easy to forget that the main initial purpose of O2 was to align S2 with the Lisbon Treaty and with the European System of Financial Supervision (“ESFS“) introduced in 2010.
The Lisbon Treaty replaced the European “comitology” procedure for adoption of technical implementing measures by a system of “delegated acts” and “implementing acts” to be adopted by the European Commission. O2 makes the necessary changes in S2 to accommodate this new system.
Under the ESFS, the European Insurance and Occupational Pensions Authority (“EIOPA“) has a larger role to play than under the former system. S2 did not provide for the necessary basis for EIOPA to fulfil its tasks as envisaged under the ESFS and set out in its founding regulation (Regulation (EU) 1094/2010). This is introduced by O2.
Roles of EIOPA
EIOPA fulfils many roles under the ESFS which are set out in its founding regulation. We note the following roles, most of which have been impacted by O2:
Advisory role (not impacted by O2)
2. Long-term guarantee package
Concerns regarding long-term guarantees had held up the negotiations on O2 for a long time. What were the discussions all about?
Long-term guarantees are part of products such as annuities. They pay fixed amounts over a defined period of time in the future. When calculating the best estimate (technical provisions), insurance obligations in principle are discounted using the relevant risk-free interest rate term structure to be published by EIOPA. It follows from the draft Delegated Acts S2 that the basic risk-free interest rates are derived on the basis of interest rate swap rates for interest rates of each currency, adjusted for credit risk. O2 describes the high level principles for extrapolation of the risk-free interest rate term structure for maturities where the markets for the relevant financial instruments or for bonds are no longer “deep, liquid and transparent”. Further detail is provided in the recitals of O2 and in the draft Delegated Acts S2.
The discounted best estimate is higher if the discount rate is lower. Insurers have argued that with respect to long-term guarantees they should be allowed to use a higher discount rate (i.e., add a premium to the risk-free rate). Their reasoning is that they can match the long-term guarantees with assets that have long maturity dates. As they aim to hold these assets to maturity, they do not run any risks with respect to these assets other than outright default. In other words: insurers reason that they do not run all the risks with respect to those assets that other investors do. Therefore, the part of the spread on that asset that does not correspond with the “fundamental spread” (corresponding to default risk) should be added to the risk-free interest rate term structure. This is exactly what the “matching adjustment”, introduced by O2, does, although it also includes the risk of a downgrade in the fundamental spread. If an insurer were not allowed to make this adjustment, there would be artificial volatility in its own funds. This would be the result of the value of its assets (bonds) going down if the spread, other than the fundamental spread, for those bonds goes up while the value of its technical provisions (the largest part of the liabilities of an insurer) would not be reduced. This results in lower own funds (in short, assets minus liabilities) while the reduced value of the assets will not be realised. Of course, the opposite applies if the spread goes down.
A flanking measure is the volatility adjustment. This adjustment is aimed at preventing pro-cyclical investment behaviour. The long-term guarantee package is completed by transitional measures with respect to the risk-free interest rate structure and the technical provisions.
Although O2 technically does not limit the use of the long-term guarantee measures to long-term guarantees, they will have the greatest use with respect to these obligations. This is because a change in a discount rate has a bigger effect when discounting takes place over a longer period.
The matching adjustment allows an insurer, subject to approval from the relevant supervisory authority, to apply a premium to the relevant risk-free interest rate term structure to calculate the best estimate. As a maximum the matching adjustment is 70% of the spread on (in short) EEA sovereign debt and 65% of the spread on other debt. It follows from the draft Delegated Acts S2 that extrapolation must be based on the risk-free interest rates without a matching adjustment. The matching adjustment must be applied to the extrapolated risk-free interest rates.
The matching adjustment may only be used if certain strict conditions are met. Most importantly:
There is no requirement to substitute assets if they no longer have a certain credit quality, as was the case in previous thinking on the matching adjustment. We therefore wonder whether the risk of a downgrade should still be seen as a separate risk that an insurer runs with respect to its long-term guarantees and whether it should therefore be part of the fundamental spread (see the introduction to this section).
The matching adjustment cannot be used in conjunction with the volatility adjustment or the transitional measure with respect to the risk-free interest rate structure. It is unclear whether the matching adjustment can be used in combination with the transitional measure with respect to the technical provisions.
The volatility adjustment allows insurers to increase the relevant risk-free interest rate term structure for the calculation of the best estimate by 65% of the portion of the spread of a reference portfolio that is not attributed to “a realistic assessment of expected losses or unexpected credit or other risk of the assets”. It follows from the draft Delegated Acts S2 that this – as with the matching adjustment – comes down to (65% of) the spread minus the fundamental spread. There is also an additional allowance for a risk-corrected country spread. The volatility adjustment applies only to the risk-free interest rates of the term structure that are not derived by means of extrapolation and the extrapolation of the term structure must be applied on those risk-free interest rates including the volatility adjustment.
As follows from its name, there is no requirement for the insurer to hold the assets in the reference portfolio, as is the case with respect to the matching adjustment. However, to the extent the assets actually held by the insurer differ from the assets in the reference portfolio, the effectiveness of the volatility adjustment will diminish.
The requirements to be met by the reference portfolio are set out in the draft Delegated Acts S2. We note that the reference portfolio may consist of bonds, securitisations, loans, equity and property, that the assets must be representative of the investments made by insurers (it seems, in general) to cover the best estimate and that, where available, the portfolio must be based on relevant indices. Member states may require prior approval by supervisory authorities for insurers to apply a volatility adjustment.
The volatility adjustment cannot be combined with the matching adjustment. The interplay between the volatility adjustment and the transitional measure with respect to the risk-free interest rate structure is complicated, but effectively comes down to the transitional measure taking precedence, while the calculation is based on the volatility adjusted risk-free interest rate. The calculation under the transitional measure with respect to the technical provisions is based on the volatility adjusted risk-free interest rate, but it seems that the volatility adjustment can also be used in conjunction with the transitional measure.
The transitional measure with respect to the risk-free interest rate term structure allow insurers for insurance obligations existing on 31 December 2015, subject to prior approval by the supervisory authority, to phase into the S2 term structure over a period of 16 years. As many Dutch insurers use the DNB published risk-free interest rate term structure, we do not expect this transitional measure to be of much significance for them.
The transitional measure with respect to the technical provisions allow insurers, subject to prior approval by the supervisory authority, to phase into the S2 calculation of the technical provisions over a period of 16 years. The transitional measure seems to effectively only relate to insurance obligations existing on 31 December 2015.
These transitional measures may not be combined. See the sub-sections Matching adjustment and Volatility adjustment for the possibility of combining the transitional measures with the matching adjustment or the volatility adjustment.
An insurer that applies either transitional measure and observes that it would not meet the solvency capital requirement without application of that transitional measure must inform the supervisory authority as soon as possible. In a phasing-in plan, the insurer should set out the measures planned to ensure compliance at the end of the transitional period.
Consequences of using the long-term guarantee measures
The long-term guarantee measures are quite technical and form a playground for actuaries. The matching adjustment and the volatility adjustment should result in less volatile own funds, while the transitional measures provide for a gradual phasing-in to the S2 regime. But applying these measures has an impact that is much wider than one might assume when looking at the measures as such. Therefore, not only actuaries should concern themselves with these measures. As an initial orientation we have summarised the consequences of using the long-term guarantee measures.
An insurer must also regularly assess the sensitivity of its technical provisions and own funds to the assumptions underlying the extrapolation of the relevant risk-free interest rate term structure.
3. Third country equivalence
The question whether a third country’s solvency regime is equivalent to the regime under S2 is relevant in three areas.
The outcome of these tests is relevant for any internationally active insurer or insurance group. Each will have to assess the impact of third country equivalence on their reinsurance business, group solvency calculation and group supervision. The new elements brought by O2, which we discuss below, are important for this assessment as they widen the possible scope of third country equivalence.
As provided by S2, the Commission has set out in its draft Delegated Acts S2 the criteria to be met by a third country to be considered equivalent. A different set of strict criteria applies to each area. It has become apparent that not many third countries will fulfil these criteria. Only Bermuda and Switzerland are on track to obtain this status. This is why O2 introduces two new forms of equivalence:
The temporary equivalence regime is available with respect to reinsurance activities and group supervision. Provisional equivalence is introduced with respect to the group solvency calculation.
Temporary equivalence is awarded until 31 December 2020 (five years), with the possibility of extension for one year. When a third country’s regime is considered temporarily equivalent, the same benefits apply as with respect to fully equivalent countries. With respect to group supervision, an exception applies if there is an EEA insurer within the group that has a balance sheet total that exceeds the balance sheet total of its third country parent.
Obviously, the conditions for temporary equivalence as set out in O2 are lighter than those for full equivalence. These conditions may still be further specified by the Commission in the Delegated Acts S2, but this is not yet included in the draft dated 14 March 2014. The most important condition is that the third country must give a commitment to adopt and apply a prudential regime that is capable of being assessed as equivalent and to engage in an equivalence assessment process in the future. The third country must have a work programme in place and allocate sufficient resources to fulfil its commitment. The current prudential regime must be risk based and establish “quantitative and qualitative solvency requirements and requirements relating to supervisory reporting and transparency and to the supervision of groups”. The third country must also have an independent system of supervision.
Provisional equivalence is granted for ten years and may be renewed indefinitely with additional periods of ten years. When a third country’s regime is considered provisionally equivalent, the same benefits apply as with respect to fully equivalent countries.
The conditions for provisional equivalence are set out in O2. The Commission does not have the possibility to further detail these conditions in the Delegated Acts S2. The most important difference from the temporary regime is that the third country does not have to commit to adopt a regime that is capable of being assessed as equivalent to the S2 regime. It is sufficient that it can be shown, not necessarily by the third country, that the current system would be able to meet the full equivalence requirements, or that that regime may be adopted in the future. No time limit is set for this adoption in the future.
This outcome is good news for insurers with a subsidiary in a third country. If that third country is considered to have a prudential regime in place that is provisionally equivalent, the insurer is able to use the third country calculations for the required and available capital of the subsidiary for at least ten years and probably for additional periods of ten years. This diminishes the risk that an insurance group must hold further own funds for its third country subsidiary than follows from the rules of that third country. As set out above, this outcome only applies if the group solvency is calculated on the basis of the deduction and aggregation method.
4. Transitional measures
O2 contains a number of transitional measures. The transitional measures with respect to the risk-free interest rate structure and the technical provisions were already discussed above (see 2. Long-term guarantee package, sub-section Transitional measures). Other examples of transitional measures included in O2 are those relating to
With respect to own funds, the transitional measures provide for a grandfathering regime with respect to capital instruments issued under current law.
Capital items that were issued prior to 1 January 2016 (or prior to the date that the Delegated Acts S2 come into force, if earlier) and that under current law can be used to meet the available solvency margin up to 50% of the solvency margin will be included in Tier 1 basic own funds for up to ten years after 1 January 2016. The wording suggests that capital items that meet the S2 requirements to directly classify as Tier 1 or Tier 2 own funds, cannot rely on this transitional measure. This seems to mean that in theory an insurer could end up with own funds with a lower classification than they could have had (Tier 1), simply because they meet the S2 requirements to qualify as Tier 2 own funds. Whether this will pose a problem in practice remains to be seen.
Capital items that were issued prior to the cut-off date and that under current law can be used to meet the available solvency margin up to 25% of the solvency margin will be included in Tier 2 basic own funds for up to ten years after 1 January 2016.
This grandfathering regime may lead to the conclusion that up to 1 January 2016 insurers can continue to issue capital instruments without taking the S2 requirements into account. However, as it has become market practice to take these new requirements into account, we believe it unlikely that the Dutch Central Bank would find that acceptable. In any case, insurers should carefully assess the classification of their current capital items under S2.
Non-compliance with the solvency capital requirement
The transitional measures provide a grace period for insurers that meet the solvency rules on 31 December 2015, but do not comply with the S2 solvency capital requirement on 1 January 2016. In that case the relevant supervisory authority must require that the insurer take the necessary measures to ensure compliance by 31 December 2017.
5. Phasing-in S2
The S2 rules, as amended by O2, that bring about novelties must be transposed in national law by 31 March 2015. They, and the rest of S2, must apply as from 1 January 2016. The only exception to this rule is that the S2 phasing-in provision, introduced by O2, must already apply from 1 April 2015.
The phasing-in provision requires that supervisory authorities have certain powers prior to the entry into force of the national S2 implementation acts. This ensures that certain steps for the preparation of S2 can already be set prior to its application date. For instance, from 1 April 2015 supervisory authorities must have the power to decide on the approval of a full or partial internal model and on ancillary own funds. As of the same date the supervisory authorities should have the power to identify the group supervisor and to establish a college of supervisors. From 1 July 2015, supervisory authorities must have the power to, for instance, make a determination of third country equivalence and determine the application of transitional measures.
Insurers now know for certain as from what date they may expect decisions from their supervisory authorities on certain important topics, such as the approval of their internal model.
6. Other changes
We highlight a few other changes brought about by O2.
What can De Brauw Blackstone Westbroek do for you?
The Insurance practice of De Brauw Blackstone Westbroek closely follows the Dutch and European developments that are relevant for insurers. Obviously, S2 is a very important part of these developments.
Our specific expertise in both current law and S2 includes:
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