CEIOPS’ Advice for Level 2 Implementing
Measures on Solvency II:
Own funds - Article 97 and 99 -
Classification and eligibility
October
2009
3.1.3 Basic own
funds
a) Tier 1
requirements
Capital instruments
3.78. Unlike own funds that an
undertaking generates as part of its ongoing business activities,
raising own funds involves issuing capital instruments to investors
(including to an entity within a group) who assume risk in return
for yield.
3.79. In determining whether a Tier 1
own fund item is loss absorbent in a going concern and in a
winding-up, Article 93 requires, in addition to the characteristics
of permanent availability and subordination, the
following features to be taken into
consideration:
• sufficient duration;
• free from
requirements/incentives to redeem the instrument;
• absence of
mandatory fixed charges; and
• absence of
encumbrances.
3.80. Tier 1 is one of the key
measures that both supervisory authorities and the markets use to
determine an undertaking’s capital adequacy.
This reinforces the need to ensure that
own fund items included in Tier 1 are of the highest quality and
demonstrably absorb unexpected losses to enable an undertaking to
continue as a going concern.
3.81. In the context of capital
instruments, the own fund item that unequivocally meets this test is
ordinary share capital or the equivalent capital of mutual and
mutual-type undertakings.
The reason that this type of own fund
item is considered to be the best quality is that
it:
• absorbs losses before all other
capital instruments;
• absorbs losses as and when they
occur; and
• ranks below all other capital
instruments in a liquidation.
3.82. This type of capital absorbs
the first loss because there is no preference as to either income or
return on capital.
Where own fund items have a preference
with respect to either coupon payments or repayment of principal,
the capital is less loss absorbent than ordinary
shares.
3.83. The deepest subordination of
Tier 1 could provide a distinction in the quality of own funds in a
going concern.
For example, it could reinforce the
perceived solidity of an undertaking’s capital and enhance
confidence in the undertaking, which could facilitate raising
capital when access to capital markets is restricted.
Deepest subordination is consistent with
the requirement for Tier 1 to be loss absorbent on a going concern
basis as the level of subordination is closely linked to the
appetite of investors to absorb losses.
For example, Tier 1 instruments that rank
above ordinary shares will not take losses until common equity has
been exhausted.
Deepest subordination for Tier 1 would
also be in line with developments in the banking regime.
Despite the fact that deepest
subordination represents an additional cost to the (re)insurance
undertaking, theinclusion of hybrid instruments within Tier 1, means
that there exists an additional buffer of eligible own funds for
policy holders and senior creditors to rely upon to absorb losses in
a winding up situation.
Against this background, CEIOPS believes
that all Tier 1 instruments should be the most deeply subordinated
in a winding-up.
3.84. Therefore, consistent with a
rigorous definition of substantially loss absorbent, Tier 1 own
funds should display the following key features:
i.
Subordination: the item must be
the most deeply subordinated in a winding-up.
ii.
Loss absorbency: the item must be
fully paid in, must be the first instrument to absorb losses or rank pari passu with an instrument that substantially absorbs first
losses, and must not hinder recapitalization.
iii.
Sufficient duration: the item should
not have a legal maturity of less than 10 years at issue date.
The item must be contractually locked-in
on a breach of the Solvency Capital Requirement where redemption is
only
permitted in exceptional circumstances, if the item is
replaced by an own fund item of equivalent or higher quality and
subject to the consent of the supervisory
authority.
iv.
Free from requirements or
incentives to redeem: there must be no incentives to redeem the
item.
An incentive to redeem is a feature which
in conjunction with a call would make the undertaking more likely to
redeem the instrument.
The item must only be redeemable at the
option of the undertaking (i.e. not at the option of the holder) and
any
redemption should be subject to the approval of the
supervisory authority.
v.
Free from mandatory fixed charges:
at all times coupons/dividends must be able to be cancelled and must
at a minimum be cancelled on a breach of the Solvency Capital
Requirement after which they can only be paid in exceptional
circumstances and subject to the consent of the supervisory
authority.
Undertakings should have full discretion
over the amount of payment; coupons/dividends must not be at a fixed
rate and
there should be no preference as to income or return of
capital.
CEIOPS maintains its view that an MCR
based trigger would be ineffective given than an MCR breach results
in ultimate supervisory action.
Any trigger between the MCR and the SCR
would create an additional level for the undertaking to monitor and
would not be consistent with the Level 1 text.
A trigger based on the SCR is therefore
needed to ensure that action is taken sufficiently early to maintain
the undertaking as a going concern.
vi.
Absence of encumbrances: the
instrument must be free from encumbrances and therefore should not
be connected with any other transaction which, when considered with
the own fund item, could undermine the characteristics of that item.
Examples of potential encumbrances
include, but are not limited to, rights of set off, restrictions,
charges or guarantees. Where an investor subscribes for capital in
an undertaking and at the same time that undertaking has provided
financing to the investor, only the net financing provided by the
investor is considered as eligible own funds.
Other own fund items
References in the Level 1
text
3.85. The Level 1 text refers to the
‘excess of assets over liabilities’ in three places: recital 48,
recital 49 and Article 88. In particular, Article 88 states that the
‘excess of assets over liabilities’ shall be considered as basic own
funds.
3.86. The Level 1 text makes no
explicit reference to how the ‘excess of assets over liabilities’
should be classified. Article 93 mentions the characteristics and
features that shall be used to classify own funds into
tiers.
3.87. In this connection,
CEIOPS
notes that the Level 1 text does not provide a definition for
‘assets’ or ‘liabilities’, leaving the meaning of the excess of
assets over liabilities open.
CEIOPS’ advice on the valuation of assets
and liabilities (other than technical provisions) relies on the same
definitions for assets and liabilities as those used for
accounting purposes as the use of a substantially different
definition does not seem the intention of the Level 1 text (see for
example Recital 46: Valuation standards for supervisory purposes
should be compatible with international accounting developments, to
the extent possible, so as to limit the administrative burden on
insurance or reinsurance undertakings.).
3.88. In order to
analyse how to develop implementing measures in this respect, CEIOPS
notes in the Level 1 text that:
a. the ‘excess of assets over
liabilities’ shall be classified as ‘basic own funds’ (Article
88),
b. ‘basic own funds’ shall be reduced
by the amount of own shares held by the insurance or reinsurance
undertaking (Article 88).
According to the principle of substance
over form, CEIOPS believes that where there is evidence of a group
of connected transactions whose economic effect is the same as the
holding of ‘own shares’, the assets that those transactions generate
for the undertaking shall be deducted from its own funds, to the
extent necessary to guarantee that own funds reliably
represent
the net financial position of its shareholders, further to other
allowed items.
c. ‘basic own funds’ not classified
as Tier 1 or Tier 2, shall be classified as Tier 3 (Article
94.3).
3.89. Recital 48
states the following
in relation to the classification of the ‘excess of assets over
liabilities’ into tiers:
Generally, assets which are free from
any foreseeable liabilities, are available to absorb losses due to
adverse business fluctuations, both on a going-concern basis as well
as in the case of winding-up.
Therefore the vast majority of the excess
of assets over liabilities, as valued in accordance with the
principles set out in this Level 1 text, should be treated as high
quality capital (Tier 1).
3.90. Recital 48 in conjunction with
articles 88, 93 and 94, show that the Level 1 text recognizes that
not all elements of the ‘excess of assets over liabilities’
necessarily meet the requirements of Article 94.1 to be classified
as Tier 1.
Consequently, although a ‘vast majority’
(as expressed in recital 48) of elements meet such requirements,
some elements may not.
3.91. In other words, when
classifying elements of the excess of assets over liabilities into
tiers, differences in their loss-absorption capacity has to be taken
into consideration to comply with the Level 1 text.
CEIOPS notes that in this regard there
may be some conflict between Solvency 2 requirements and
restrictions or requirements created under national
law.
3.92. The European Commission has
indicated to CEIOPS that its interpretation of the Level 1 text is
that once assets and liabilities are valued under article 75, the
net arithmetical result constitutes own funds.
The own funds articles merely require
classification into tiers and do not permit any item to be excluded
or the amount at which it is recognised adjusted on the grounds of
lack of quality eg availability and/or loss
absorbency.
3.93. This interpretation was not the
understanding of CEIOPS members at the time the Level 1 text was
developed.
The advice set out in the consultation
paper was drawn up on the basis that potential own funds items need
to be assessed firstly to establish whether they have the necessary
quality to be eligible as own funds and secondly allocated to tiers
having regard to their particular characteristics.
There is a clear distinction between the
valuation of particular items on an economic basis and the extent to
which they can properly contribute to capital available to meet
the risks arising in a (re)insurance undertaking. CEIOPS remains of
the view that the approach adopted in the consultation paper is
necessary to deliver a prudentially sound regime for own funds under
Solvency II.
CEIOPS also notes the importance of
cross-sectoral consistency and considers there are no sound reasons
for there to be an inconsistent approach.
This is particularly the case given
international consensus confirmed by the G20 on the importance of
the quality of capital in the financial services
sector.
3.94. In the advice which follows the
consultation CEIOPS has indicated where it considers items should be
restricted in their inclusion in own funds in accordance with the
above.
However recognising the position of the
Commission CEIOPS has also indicated treatments which may satisfy
the
alternative interpretation put forward by the Commission.
In most cases this involves classifying
items in tier 3 and/or introducing an appropriate risk
charge.
3.95. CEIOPS has identified elements
of the ‘excess of assets over liabilities’ with
restricted
loss-absorption capacity either on a going-concern basis or in the
case of winding-up and has analysed these characteristics separately
for classification into tiers.
Among others:
a. Reserves, the use of which is
restricted.
b. The difference between the value
of technical provisions calculated in accordance with Articles 75 to
86 - that is, on a going concern basis - and the amounts that the
original undertaking shall have to pay to its policyholders to
honour their rights according to the contracts in force in the case
of winding up with no transfer of portfolios is known as the
“winding-up
gap” where such a difference exists.
This calculation shall allow for the
amounts that policyholders are legally or contractually obliged to
pay to the
undertaking in a situation of winding up.
The existence of this winding up gap
would depend for every contract on the link between the
policyholders’ rights when the contract is cancelled in winding up
and the technical provisions calculated by the
undertaking.
c. Deferred tax
assets.
d. Intangible
assets.
3.96. To comply with the Level 1
text, including recitals 48 and 49, CEIOPS considers that elements
of the ‘excess’ which do not meet the requirements of Article 94.1
to be classified as Tier 1 should be classified in a lower tier or
restricted as to their inclusion in own funds, where classification
would be based on an assessment against the criteria set forth in
Article 93.
3.97. CEIOPS reads Article 93 to mean that the
loss-absorption capacity of an item requires the capacity to absorb
any type of losses (wherever they arise in the undertaking’s
business), regardless of the solvency position of the undertaking
(assuming the undertaking is able to continue its business or enters
into winding up, whether it can, or cannot, transfer its
portfolios
of contracts and assets).
3.98. This approach has the merit of
guaranteeing that no item with restricted or limited loss-absorption
capacity is classified as own funds or Tier 1 as appropriate), which
appears to be the aim of Article 94 and recital 48.
3.99. The consequences of this
approach may be summarized as follows:
a) Reserves, the use of which is
restricted
3.100.These should only be eligible
for inclusion in own funds in relation to the risks they cover.
(CEIOPS’ preferred option) Some CEIOPS Members consider this
approach to be similar to the approach adopted for ringfenced funds
in QIS4.
3.101. As explained in paragraph 3.94
an alternative approach to meet the Commission interpretation is
that all reserves should be compared with the key features for T1
and T2; restricted reserves should move to Tier 3 if these features
are not met.
b) Winding up gap (for further
background see Annex A).
3.102.The Level 1 Text recognises
that the elements of the excess of assets over liabilities can have
diverse levels of loss absorption capacity; therefore this has to be
taken into account when classifying them into tiers.
The loss absorption capacity of an item
requires the capacity to absorb losses on a going and gone concern.
Given that the winding up gap lacks loss
absorption capacity, in the case of winding up where there is no
transfer of
portfolios, this item is neither available to absorb
losses in a going-concern basis nor in the case of a winding-up, and
consequently, it does not possess the characteristic set forth in
Article 93.1a for classification as Tier 1.
The winding-up gap, by definition,
will
be paid to the policyholders in the case of winding-up.
Consequently, it does not possess the
characteristics set forth in Article 93.1b for classification as
Tier 2.
According to the Level 1 Text, own
funds items which do not possess the characteristics and features to
be classified as Tier 1 or Tier 2, shall be classified as Tier
3.
3.103.The proposed treatment for this
item is an immediate consequence of the principles set out in
Articles 93 and 94 of the Level 1 text.
While Article 88 of the Level 1 text sets
out clearly an automatic recognition as eligible basic own funds of
the excess of assets over liabilities, at the same time Article
94(2)(3) explicitly recognizes that items of basic own funds should
be tested against the criteria set out in Article 93.
These criteria also set out explicitly
that Solvency II aims to protect policyholders’ rights both in a
going concern and winding up. Furthermore, as in Solvency I,
Solvency II aims to guarantee policyholders’ rights both when the
portfolio of contracts of the undertaking in difficulties may be
transferred and in those situations where such transfer is not
possible due market conditions, as occurred in the recent crisis.
This important issue for consumers should
be respected in the assessment of the quality of own funds and
their
classification into tiers.
3.104.As already stated in this
advice, CEIOPS is committed to achieving the aim of high quality
capital that is measured according its loss-absorbency capacity in a
going concern as well as a winding up.
CEIOPS thinks this is the consistent way
to proceed according to the Level 1 text, which explicitly
recognises the distinct quality of different own funds items by
requiring classification into three tiers.
Articles 93 and 94 should be applied in
such a manner that items of own funds are considered as high quality
capital only when they substantially absorb losses in all of the
situations where it is necessary to protect policyholders’ rights.
3.105.CEIOPS recognises that the winding
up gap is not applicable in all jurisdictions and
contracts.
c) Deferred tax assets
3.106.CEIOPS is of the view that the
Level 1 text is unclear on the treatment of deferred tax
in general,
i.e. both deferred tax assets and deferred tax liabilities.
It is also a complex issue which is
linked to the SCR, valuation, fungibility/transferability and
accounting.
3.107.Any treatment of deferred tax
assets in own funds would necessarily depend on the general approach
to deferred tax.
3.108.On the basis that
deferred tax will
be calculated on the entire solvency balance sheet, and considering
that deferred tax assets are assets of a contingent nature
representing losses that can be offset against future taxable
profits, CEIOPS considers that deferred tax assets could be treated
in one of two ways.
3.109.Underlying both options is the
consideration that, as the solvency position of an undertaking
deteriorates, the accounting value of deferred tax assets rises,
while their economic value falls.
Recognising such assets in full appears
contradictory to the aim of the solvency balance sheet.
Also, care should be taken to avoid
counting the benefit of deductible tax losses twice in the
assessment of the solvency position of undertakings.
If deferred tax assets are recognised as
having some loss absorbing capacity, they increase the value of
assets, thereby the excess of assets over liabilities and thereby
the value of basic own funds used to cover the Solvency Capital
Requirement; while when calculating the Solvency Capital Requirement
using the standard formula, the SCR of an undertaking can be
decreased for the loss-absorbing capacity of deferred
taxes.
3.110.The two approaches can be
described as follows:
The assets do not absorb losses in a
going concern or in a winding up and should be excluded entirely
from own funds (apart from the amount expected to be used in the
next twelve months or unless they can be transferred to another
entity – in accordance with the relevant tax legislation): as the
realisation of deferred tax assets is dependent on future taxable
income, they are of limited value for the undertaking in terms of
their ability to absorb losses in times of stress/deficits or
in
a winding-up.
• The assets may have
limited loss
absorbing capacity: The realisation of deferred tax assets depends
on making the relevant future taxable income and have a zero value
on winding up unless they can be transferred to another entity.
Therefore, apart from the amount expected
to be used in the next twelve months, unless they can be transferred
to another entity – in accordance with the relevant tax legislation
– they should be classified in Tier 3.
d) Intangible assets
3.111.To the extent that intangible
assets, other than goodwill, have been purchased, and can be readily
resold, they should be treated as any other asset, to the extent
that they are subject to a capital charge.
Intangible assets not valued at zero and
not subject to a capital charge should be excluded from own
funds.
3.112.If this is not deemed possible
in line with the Commission’s interpretation, intangible assets
should be regarded as Tier 3. However in this case, in order to
ensure that the risks attaching to intangible assets are
addressed CEIOPS recommends the introduction of an intangible
asset risk module in the SCR standard formula. A detailed
explanation underpinning this
proposal is set out in Annex
B.
Expected future
profits
3.113.This advice described the need
for further analysis in respect of the item then called ‘profits
at inception’.
This expression was used to facilitate
the consultation process, since its meaning is widely understood
in the insurance industry. Nevertheless, in order to provide
advice more appropriate for a legal text, from this point on this
item will be referred to as ‘expected future
profits’.
3.114.The following paragraphs
reflect the output of the further analysis carried out by CEIOPS,
where comments from stakeholders, resulting from the consultation
process, have been considered carefully.
3.115.‘Expected future profits’ are
defined as the actual value of any type of profit included,
either explicit or implicitly, in the future inflows
considered in the calculation of the best
estimate.
3.116.According to the provisions set
out in articles 75 to 85, the ‘expected future profits’,
contribute to the excess of assets over liabilities and therefore
they are an element of the basic own funds. The Level 1 text
requires testing of this item, as any other, against the
loss-absorbency criteria set out in articles 93 and
94.
3.117.Solvency II aims to guarantee a
99.5 per cent confidence level, protecting policyholders’ rights
where there is a transfer of the business of the undertaking in
difficulties, even in circumstances where such a transfer
is problematic.
Where this is the case to the extent that the
transfer is not possible ‘expected future profits’ represents an
item with no capacity for loss absorption.
3.118.In case of negative deviations
in the insurance business, proceeding from the actuarial
assumptions underlying the calculation of technical provisions,
and therefore underlying the amount of ‘expected future profits’,
it is clear that the SCR provides the adequate protection at
the targeted level of confidence.
3.119. Nevertheless in case of
negative deviations proceeding from other sources (i.e.
operational risk, market risks or counterparty default risks), the
item corresponding ‘expected future profits’ does not provide
funds available to
absorb the losses, unless the portfolio is
transferred. And this lack of protection applies both in going
concern and in case of termination of
the activity.
3.120.If ‘expected future profits’ is
allowed to be counted as a tier 1 item, an insurance undertaking
could hold 100% of its own funds in the form of this item.
This
does not protect policyholders’ rights, since the
undertaking would not hold own funds to face any deviation
derived from the sources mentioned in the previous paragraph if
it fails in transferring the insurance portfolio (‘expected
future profits’ are not actually available funds to face losses
due to, i.e. market falls or defaults of counterparties if the
portfolio
is not transferred).
3.121.In this respect and in light of
the recent crisis, CEIOPS has observed that there is a direct
link between financial crises and tightening of market conditions
to transfer portfolios.
In other words, in situations of
financial crisis (where negative deviations mentioned in 3.7 are
frequent), transfers
of portfolio are more uncertain and at the
same time the own funds held as ‘expected future profits’ will
display no loss absorption capacity.
This exposes undertakings in
difficult situations to failure in honouring
their commitments.
3.122.Having in mind this legal and
technical rationale, CEIOPS has concluded that classifying
‘expected future profits’ as tier 3, is the more appropriate and
legally necessary solution according to article 94(3) as this item
does not possess the characteristics necessary to be considered
as tier 1 or 2.
However insurance contracts which are subject to
consideration under the winding up gap may also give rise to
expected future profits.
Where this is the case there should be
no double-counting of the amount excluded from Tier 1 and
classified as Tier 3
3.123.In terms of the impact of this
advice based on the Level 1 text, CEIOPS notes that Solvency I
only allows future profits for life insurance business under
restrictive requirements.
These profits currently represent a
very limited proportion of own funds.
3.124.Conversely,
Solvency II expands the allowance of ‘expected future profits’ to
any type of insurance business (therefore, life, non-life and
health).
3.125.Finally and considering
cross-border consistency and effects, at least two considerations
seem relevant.
Firstly, an allowance of this item as tier 1 might
have significant consequences endangering a level playing
field
among sufficiently similar cross-border activities. In the
same line, expanding an allowance as tier 1 of this ‘expected
future profits’ to other financial sectors would likely undermine
the current efforts to foster the stability of the financial
system.
b) Tier 2
requirements
3.126.In accordance with Article
94.2, basic own fund items are classified in Tier 2 where they
substantially possess the characteristic set out in point (b)
of Article 93.1, taking into consideration the features set out
in Article 93.2.
3.127.In determining whether a Tier 2 own fund
item is loss absorbent in a winding-up, Article 93 requires, in
addition to the characteristics of subordination, the following
features to be taken into consideration:
• sufficient
duration;
• free from requirements/ incentives to redeem the
instrument;
• absence of mandatory fixed charges; and
•
absence of encumbrances.
3.128.Tier 2 basic own funds are the
second line of defence after Tier 1, and need to absorb losses
when Tier 1 is depleted.
3.129.As such, they can be of a lower
quality than Tier 1. At the same time, they should absorb losses
to a greater degree than Tier 3 basic own funds.
3.130.When an undertaking's solvency
position is not deteriorating, or is not expected to deteriorate,
Tier 2 basic own funds can provide a cheaper source of finance
than Tier 1.
3.131.However, overreliance on Tier 2
basic own funds could cause refinancing problems for an
undertaking when it needs financing, unless the funds can convert
into Tier 1 upon a trigger event.
3.132.Therefore, a balanced approach
to Tier 2 basic own funds appears appropriate.
3.133.Tier 2 basic own funds do not
need to absorb the first loss.
So, preference with respect to
return on capital may be allowed.
The repayment of principal may
be allowed as long as the Solvency Capital Requirement is not
breached.
3.134.Coupon payments must also be
deferred when the Solvency Capital Requirement is breached.
This
is to ensure that the payments on capital instruments do not
accelerate insolvency, which would limit the ability of
Tier 2 to
absorb losses.
3.135.Given that the Level 1 text
does not require Tier 2 basic own funds to be substantially loss
absorbent in a going concern, requiring deeper subordination than
Tier 3 basic own funds does not appear necessary, or
relevant.
3.136.In view of the considerations
set forth above, Tier 2 basic own funds should display the
following key features:
vii. Subordination: the item must be
effectively subordinated in a windingup.
viii. Loss absorbency:
the item does not need to be fully paid in, but can simply be
called up, and must absorb losses to a degree. The undertaking
must be able to defer coupon payments once the SCR has been
breached.
ix. Sufficient duration: the item
should not have a legal maturity of less than 5 years at issue
date.
The item must be contractually locked-in on a breach of the
Solvency Capital Requirement where redemption is only
permitted
if the item is replaced by an own fund item of equivalent
or higher quality and subject to the consent of the supervisory
authority.
x. Free from requirements or
incentives to redeem: there may be moderate11 incentives to
redeem the item.
The item must only be redeemable at the option
of the undertaking (i.e. not at the option of the holder) and any
redemption should be subject to the approval of the supervisory
authority.
xi. Free from mandatory fixed
charges: coupons/dividends must at a minimum be deferred for an
indefinite term on a breach of the Solvency Capital Requirement
after which they can only be paid subject to the consent of the
supervisory authority.
xii. Absence of encumbrances: the
instrument must be free from encumbrances and therefore should
not be connected with any other transaction which, when
considered with the own fund item, could undermine the
characteristics of that item.
Examples of potential encumbrances
include, but are not limited to, rights of set off, restrictions,
charges or guarantees. Where an investor subscribes for capital
in an undertaking and at the same time that undertaking
has provided financing to the investor, only the net financing
provided by the investor is considered as eligible own
funds.
c) Tier 3
requirements
3.137.The role of Tier 3 basic own
funds is to provide loss absorbency in a winding up in order to
adequately protect policyholders and beneficiaries.
This is
particularly important as Tier 3 can represent a very
substantial proportion of the undertaking's own funds unless its
eligibility is limited.
3.138.Article 94 does not require
Tier 3 basic own funds to substantially possess the
characteristics in Article 93, full loss absorbency on a going
concern basis and full loss absorbency in a winding up taking
into consideration the
features of absence of incentives to
redeem, mandatory fixed charges and encumbrances.
However, while
Article 94 does not require Tier 3 to substantially possess these
characteristics, it does not require the
characteristics and
features to be disregarded altogether.
3.139.Tier 3
capital instruments should possess at least some of
the characteristics and features required for Tier 1 and Tier 2
eligibility, but to a lesser degree.
3.140.It is clear that Tier 3 capital
instruments must be subordinated by virtue of Article 87.
The
purpose of subordination is to ensure that own funds function
effectively and absorb losses in the case of winding up
or
insolvency. In order for subordination to be effective, the
own fund item must in fact be available on winding up.
Tier 3
capital instruments should therefore be prevented from having
characteristics and features that undermine
this.
3.141.If Tier 3 capital instruments
are encumbered in any way this may undermine the effective
subordination of that item and may result in the claims of
capital holders being senior to policyholders.
3.142.Therefore, in addition to
subordination Tier 3 capital instruments must be free from
encumbrances.
There should be no redemption of Tier 3
capital instruments, or coupon payments, on a breach of the
Solvency Capital
Requirement (i.e. during the ladder of
supervisory intervention), unless the supervisory authority
determines that redemption is necessary to facilitate a
recapitalisation.
Similarly, Tier 3 capital instruments
should have a minimum maturity (e.g. 3 years).
This would
increase the likelihood the Tier 3 capital instrument will be
present for a reasonable period and available in a winding-up or
insolvency.
The shorter the maturity of an instrument the less
likely this becomes.
3.143.The features suggested above
are designed to ensure as far as possible that there is a
harmonised interpretation of what features a
subordinated liability should display in order to be included in
own funds for Solvency 2 purposes.
3.144.Tier 3 capital instruments
could also include features which could push the insurance or
reinsurance undertaking into insolvency.
CEIOPS concludes that
there should be an overarching principle that no own funds items
are allowed to cause, or accelerate, an undertaking to go into
insolvency.
In the case of Tier 3 capital instruments, preventing
redemption after a breach of the Solvency Capital Requirement
(i.e. a lock-in) and stopping the payment of coupons once the
Solvency Capital Requirement is breached, are both important
features in achieving this.
To be eligible own funds CEIOPS is of
the view that all cash flows on own fund items (i.e. both coupon
and principal payments) should be subject to supervisory approval
once the Solvency Capital Requirement is breached.
3.145.QIS 4
did not specify any characteristics for Tier 3 capital
instruments (apart from subordination).
However, for the reasons
set out above CEIOPS recommends that the implementing measures
require certain features for Tier 3 capital instruments to ensure
effective subordination and to ensure that own fund items do not
cause or accelerate insolvency.
3.1.4 Ancillary own
funds
a) Tier 2
requirements
3.146.Ancillary own funds are own
funds that can be called up to absorb losses.
For classification
in Tier 2, ancillary own fund items must be callable on demand to
absorb losses on a going-concern basis, as well as in
a winding-up.
3.147.In determining whether a Tier 2
ancillary own fund item is loss absorbent in a going concern and
in a winding-up, Article 93 requires, in addition to the
characteristics of permanent availability and subordination,
thefollowing features to be taken into consideration:
•
sufficient duration;
• free from requirements/incentives to
redeem the instrument;
• absence of mandatory fixed charges;
and
• absence of encumbrances.
3.148.In line with CEIOPS advice on
Tier 1, ancillary own fund items classified in Tier 2 should be
callable own funds of the highest quality and demonstrably absorb
unexpected losses to enable an undertaking to continue as a going
concern.
3.149.Unless otherwise stated in the
Level 1 text, CEIOPS is of the view that, for classification in
Tier 2, ancillary own fund items should represent own fund items
which, if called up and paid in, would be classified in Tier
1.
3.150.Accordingly, ordinary share
capital or the equivalent capital of mutual and mutual-type
undertakings that can be called up would be classified in Tier
2.
3.151.Hybrid capital instruments and
subordinated liabilities, to the extent that they are classified
in Tier 1, would also be classified as Tier 2 ancillary
own funds.
3.152.Therefore, classification
should be tested against the characteristics and features of the
Tier 1 item that arises through making the relevant
claim.
Reference is made to paragraph 3.84 of this paper for
those characteristics and features.
Supplementary member calls of mutual
and mutual-type undertakings
3.153.Article 96 states that any
future claims which mutual or mutual-type associations of
ship-owners with variable contributions solely insuring
risks listed in classes 6, 12 and 17 in point A of Annex 1 may
have against their members by way of a call for supplementary
contributions, within the next twelve months, shall be classified
in Tier 2.
3.154.Article 96 also states that in
accordance with sub-paragraph 2 of Article 94(2), any future
claims which mutual or mutual-type associations with variable
contributions may have against their members by way of a call
for supplementary contributions, within the next twelve months,
not falling under point 3 of subparagraph 1 (of Article 96) shall
be classified in Tier 2 where they substantially possess the
characteristics set out in points (a) and (b) of Article
93(1), taking into consideration the features set out in Article
93(2).
3.155.Supplementary member calls are
claims that a mutual or mutual-type undertaking with variable
contributions has on its members to provide consideration –
usually cash – when it sustains losses.
The
consideration received directly forms part of the undertaking’s
capital as it increases the excess of assets over liabilities.
That capital is classified as Tier 1.
3.156.In line with CEIOPS view that
Tier 1 should consist of capital of the highest quality, CEIOPS
recommends that supplementary member calls of mutual or
mutual-type associations, within the next twelve months, are
classified
in Tier 2, provided that:
• the call can be made on
demand;
• the call generates Tier 1 own funds;
• the call is
clear of encumbrances.
3.157.The call must be clear of
encumbrances while it is classified in Tier 2.
This means that
the mutual or mutual-type undertaking’s members cannot set off
the call against another claim, whereby the undertaking
would effectively forego the own funds to be
received.
3.158.In QIS4, 40% of the maximum
callable amount specified in the statutes of the mutual or
mutual-type undertaking were classified in Tier 2 ancillary own
funds, and the rest in Tier 3 ancillary own funds.
3.159.The split approach represented
a compromise. CEIOPS, then, as now, considers the split to be
arbitrary.
3.160.With the revised criteria for
Tier 1 and the proposed limit structure, CEIOPS is of the view
that the treatment of supplementary member calls as set forth in
para. 3.142 is justified.
3.161.Moreover, by taking this
approach, CEIOPS is of the view that it would avoid requiring an
overhaul of the financing structure of mutual and mutual-type
undertakings, which could result in such undertakings no longer
being viable.
b) Tier 3
requirements
3.162.Subject to the proposed limit
structure being implemented, and taking into account the
supervisory approval of ancillary own funds, CEIOPS is of
the view that Tier 3 ancillary own funds do not need to be
subject to any specific requirements.
3.1.5 Methods of supervisory
approval
3.163.The Level 1 text requires the
Commission to adopt implementing measures laying down the methods
to be used by supervisory authorities when approving the
assessment and classification of own fund items which are not
covered by the list referred to in point (a) of Article
97.1.
3.164.Supervisory approval of the
assessment and classification requires supervisory judgment; not
only because of the need to assess whether the
own fund items
possess the characteristics and features set forth in the Level 1
text and in implementing measures, but also because own
fund items can take many (legal) forms and be subject to national
specificities.
3.165.Moreover, the assessment
process needs to be flexible enough to allow the supervisory
authority to consider market innovations.
3.166.Therefore, CEIOPS recommends
that a mechanistic approach should be avoided as far as possible.
The approach to supervisory approval should
be principle-based.
3.167.While implementing measures may
suffice ultimately, CEIOPS recommends allowing room for the
criteria below to be elaborated on as part of Level 3 supervisory
guidance, should divergent supervisory practices become an issue
in practice.
3.168.CEIOPS notes that supervisory
approval should be granted before (re)insurance undertakings are
allowed to include an own fund item not covered by the
list.
3.169.The undertaking is responsible
for verifying whether its own fund items comply with the list as
well as the required characteristics envisaged in
the implementing measures for the classification in different
tiers.
3.170.Accordingly, the (re)insurer
will assess the appropriate classification of the own fund item
for which it seeks supervisory approval and whether the inclusion
of this item is compatible with the quantitative limits
envisaged by the implementing measures to cover the Solvency
Capital Requirement and the Minimum Capital Requirement.
The
(re)insurer is responsible for providing the related
documentation.
3.171.The request for approval should
include at least the following details:
• amount to be used;
•
legal form of the element to be included;
• counterparty
(belonging to the same group or not);
• the capacity of the own
funds item to absorb losses either on a going concern basis (Tier
1) or in a winding up (Tier 2 and 3);
• whether the item is fully
paid in or called up;
• duration of the item;
• existence of
requirements or incentives to redeem the instrument;
• existence
of mandatory fixed charges;
• subordination in winding up;
•
duration of insurance and reinsurance obligations.
3.172.The supervisory authority can
request further information from the undertaking.
On the basis of
the information available, the supervisory authority grants
approval; refuses approval; or grants approval for a
different
classification than requested.
The approval process: How does
the supervisory authority reach its decision?
3.173.CEIOPS recommends a three step
process when granting supervisory approval of the own fund item
not covered by the list as set forth below.
Step 1. The supervisory authority,
taking into account the legal enforceability and the
characteristics of the item, assesses to what extent it possesses
the characteristics of permanent availability and subordination.
In addition, the supervisory authority assesses whether
the duration of the item is compatible with the maturity of the
undertaking’s insurance and reinsurance obligations.
For undated
items without a call this assessment is
unnecessary.
Step 2. The supervisory authority
assesses to what extent the item possesses the features of
absence of incentive to redeem; mandatory servicing costs and
encumbrances.
Step 3. The supervisory authority
assesses whether the inclusion of the item is compatible with the
quantitative limits envisaged by implementing measures to cover
the Solvency Capital Requirement and the Minimum Capital
Requirement.
3.174.CEIOPS recommends that
(re)insurance undertakings use a similar process when seeking
approval, as this would streamline the approval
process.
3.175.In this three-step assessment
process, the supervisory authority should consider the
characteristics and requirements included in the Level 1 text and
in the implementing measures.
3.176.In principle, this supervisory
approval occurs once and is not repeated.
Approval lasts until
the legal maturity of the item.
3.177.However, CEIOPS recommends that
where the characteristics and features of the item change,
following the activation of a contractual trigger or through the
restructure of the item, the (re)insurance undertaking
should submit a new request. The supervisory authority should
carry out a new assessment and grant a new
approval.
3.178.The process would be the same
as when an item is first submitted to the supervisory authority
for assessment and approval.
3.1.6 Cross sector
consistency
3.179.CEIOPS recognizes that the
absence of cross sector consistency can create opportunities for
regulatory arbitrage. CEIOPS also recognizes that Solvency II
principles for own funds are not identical to CRD principles
for own funds.
Also, banks and insurance or reinsurance
undertakings can have different own fund structures given the
differences in the nature of their businesses and in the
contractual duration of their products.
3.180.Areas where the Level 1 text
takes a different approach compared to the CRD include the
recognition of ancillary own funds, the concept of excess of
assets over liabilities, and the “sufficient duration”
principle
3.181.These differences will not be
unwound in implementing measures and will result in some
cross-sector inconsistency.
3.182.At the same time, there are
similarities with the banking regime in specific areas.
Also,
there are areas where cross sector inconsistency cannot
be justified, with specific reference to the qualitative criteria
needed for classification in different tiers.
3.183.Areas identified where a degree
of cross-sectoral consistency could be applied, include:
•
certain aspects of the treatment of capital instruments;
• the
non-recognition of certain assets in own funds, e.g.
goodwill.
3.184.CEIOPS notes that the
definition of own funds for banks is currently
under international review.
Therefore, aligning Solvency II
implementing measures with the existing framework for banks does
not make sense;
and aligning with the evolving banking framework
is problematic, if not impossible because of timetable
differences.
However, CEIOPS is aware of endeavours
in the
banking arena to improve the quality of own funds and considers
this advice should be consistent with that aim.
3.185.For alignment between the
future insurance and banking frameworks, onsideration could be
given to the establishment, within the implementing measures, of
a future opportunity for evaluation and review for the purpose of
cross-sectoral consistency following implementation of Solvency
II.
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