CEIOPS’ Advice for Level 2 Implementing
Measures on Solvency II:
Own funds - Article 97 and 99 -
Classification and eligibility
October
2009
3.2 CEIOPS’ advice
General
3.186.Tier 1 should contain
the
highest quality own funds which fully absorb losses and enable an
undertaking to continue as a going concern.
3.187.The proportion of Tier 1 items
in eligible own funds must be significantly higher than one third
of the total amount of eligible own funds. This limit
is discussed further in paragraphs 3.192 ff.
3.188.Compared to QIS4, the average
quality of own funds should be increased by:
• increasing the amount and quality
of Tier 1;
• increasing the quality of Tier 2;
and
• decreasing the amount, and
increasing the quality, of Tier 3.
3.189.CEIOPS acknowledges that there
is a role for high quality hybrids in Tier 1, provided that in
stressed situations, they can convert or write down to provide
higher quality capital in the form of equity.
Any inclusion of
high quality hybrids should be restricted i.e. they should
account for no more than 20% of Tier 1.
3.190.To be classified as Tier 1,
capital instruments must be fully paid in.
3.191.For
inclusion in own funds, there should be certain minimum
qualitative requirements. In particular, Tier 3 basic own funds
should contribute owards avoiding insolvency as well as towards
avoiding the acceleration towards insolvency.
Proposed limit
structure
3.192.CEIOPS recommends that the
limit structure is set so as to ensure that:
• in relation to
compliance with the Solvency Capital Requirement, the proportion
of Tier 1 is greater than the proportion of eligible Tier 2,
and that the proportion of eligible Tier 2 is greater than the
proportion of eligible Tier 3.
Tier 3 may be included (subject to
the limits), regardless of whether undertakings have Tier 2
eligible own funds or not;
• in relation to compliance with the
Minimum Capital Requirement, the proportion of Tier 1 is greater
than the proportion of eligible Tier 2 basic own
funds.
3.193.CEIOPS interprets the term
eligible own funds as own funds that count toward covering the
SCR and the MCR, subject to the framework of the limits
structure.
3.194.Tier 3 basic own funds are
eligible to cover the Solvency Capital Requirement, but not
eligible to cover the Minimum Capital Requirement.
Ancillary own
funds are eligible to cover the Solvency Capital Requirement, but
not eligible to cover the Minimum Capital
Requirement.
3.195.CEIOPS recommends that, as far
as the compliance with the Solvency Capital Requirement is
concerned:
• the proportion of Tier 1 items in eligible own funds
is at least 50% of the total amount of eligible own funds (a
minority of CEIOPS members have expressed a preference for at
least 60%) and
• the proportion of Tier 3 items in eligible own
funds is set at a maximum of 15% of the total amount of eligible
own funds. The appropriate percentage would be linked to the
characteristics required for elements to be included in Tier 3,
taking into account the requirements proposed for the
characteristics required for Tier 3 in this paper (see 3.64
and 3.137 to 3.145)
3.196.At this juncture, CEIOPS believes
that, as far as the compliance with the Minimum Capital
Requirement is concerned:
• the proportion of Tier 1 items in
eligible own funds is at least 80% of the total amount of
eligible own funds.
Minimum characteristics for own
funds
3.197.Tier 3 basic own funds should
demonstrate features to ensure that subordination is effective
and not just a nominal requirement.
3.198.Tier 3 basic own funds should
not be freely redeemable, or coupons on Tier 3 basic own funds be
freely payable, when an undertaking's solvency position is
deteriorating, or is foreseen to deteriorate.
3.199.To be eligible own funds 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.
3.200.No own fund items should be
allowed to cause, or accelerate, an undertaking to go into
insolvency.
3.201.Any redemption, conversion or
exchange of capital instruments, including any premiums paid in
on those instruments, should be subject to prior supervisory
approval.
Sufficient duration
3.202.Capital instruments should be
included in own funds on the basis of their issue
date.
3.203.The duration of the capital
instrument is defined as the first contractual possibility of
repayment. When determining duration, the time horizon must be
the expected duration, or anticipated duration over the
next twelve months.
3.204.Capital instruments should have
benchmark minimum maturities to ensure that capital is of a
sufficient duration. With this in mind CEIOPS recommends that the
minimum maturity at issue date should be:
• 10 years for Tier
1,
• 5 years for Tier
2,
• 3 years for Tier
3,
3.205.Issuers should still take into
account the maturity profile of their liabilities in order to
have in place adequate capital management plans, and to ensure
consistency with the Level 1 text.
3.206.The average duration of
own fund items should not be significantly lower than the average
duration of an undertaking’s liabilities. The undertaking must
assess the sufficient duration of own fund items on a reporting
date basis as part of its risk management. This assessment would
be part of the ORSA and the supervisory review process, and would
be disclosed to the public.
Basic own funds
a) Tier 1
requirements
Capital instruments
3.207.List:
a. Paid in ordinary share
capital
b. Paid in equivalent of ordinary
share capital of mutual and mutual-type
undertakings.
c. Other paid in capital instruments,
including preference shares that absorb losses first or rank pari
passu, in going concern, with capital instruments that absorb losses
first.
a. Instruments that automatically
convert to ordinary share capital, or to the equivalent of ordinary
share capital of mutual and mutual-type undertakings, as and when
the undertaking needs to absorb losses, and in any case when the
undertaking breaches its Solvency Capital
Requirement.
b. Instruments subject to write down
as long as losses persist, as and when the undertaking needs to
absorb losses, and in any case when the undertaking breaches its
Solvency Capital Requirement.
3.208.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.
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 SCR 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.
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.
3.209.In relation to the requirement
that the own fund item does not hinder recapitalization, this should
be taken to mean that the investors are the first to be called upon
to recapitalize the undertaking, if Tier 1 capital instruments are
ordinary share capital or the equivalent capital of mutual or
mutual-type undertakings.
3.210.In relation to hybrid Tier 1
capital instruments, the requirement that the own fund item does not
hinder recapitalization should be taken to mean that the instrument
absorb losses in going concern through appropriate mechanisms so
that potential future outflows to the holders of the instrument are
reduced.
3.211.In both cases, the principle
underlying the requirement that the own fund item does not hinder
recapitalisation is that Tier 1 capital instruments must absorb
losses first.
Other own fund items
3.212.List:
a. Reserves, to the extent that they
are available to absorb losses at any time arising from any segment
of liabilities or from any risks, including:
i. retained earnings
ii. share
premium account
iii. surplus funds falling under Article
91(2)
iv. revaluation reserves
v. other reserves
b. Paid in
subordinated mutual member accounts
Less:
c. Own shares,
or units of equivalent capital of mutual and
mutual-type undertakings, held by the undertaking.
Adopting an
economic approach and applying the principle of substance over
form, 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.
Excluded from Tier 1
excess of assets
over liabilities are:
a. Reserves, the use of which is
restricted, should only be eligible for inclusion in own funds in
relation to the risks they cover.
The amount in excess of that
covering the related risks should therefore be excluded from own
funds (CEIOPS preferred option) or as explained in paragraph
3.101 the excess item should be included under tier
3.
b. The difference between the value
of technical provisions calculated in accordance with Articles 75
to 86, i.e. 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.
Where such a
difference exists, it should be classified as Tier 3.
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. (“winding-up gap”)
c. Deferred tax assets, which should
be excluded from own funds or be classified in Tier 3 . See
paragraphs 3.222 to 3.223 below.
d. Intangible assets not valued at
zero and not subject to a capital charge should be excluded from
own funds or included as Tier 3 and subject to an intangible
asets risk module. See paragraph 3.224 below.
e. Expected future
profits See paragraphs 3.216 to 3.221 below
3.213.The European Commission has
indicated to CEIOPS members 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.
3.214.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.
3.215.In
the advice 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 a treatment 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.
3.216.‘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. Implicit
profits shall be assessed using appropriate actuarial
methods.
3.217.According to the provisions set
out in articles 75 to 85, the ‘expected future profits’, as
defined above, 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 this item, as any
other, against the loss absorbency criteria set out in articles 93
and 94.
3.218.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.
3.219.Having in mind this legal and
technical rationale, CEIOPS has concluded that qualifying
‘expected future profits’ as tier 3, is the more appropriate and
legally necessary solution according article 94(3), since 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 referred to in paragraph
3.212 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.
3.220.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.
3.221.Conversely,
Solvency II expands
the allowance of ‘expected future profits’ to any type of
insurance business (therefore, life, non-life and
health).
3.222.Any treatment of deferred tax
assets in own funds would necessarily depend on the general
approach to deferred tax. 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.
• 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 or unless
they can be transferred
to another entity - in according with the
relevant tax
legislation - they should be included in Tier 3.
3.223.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.
Care should be taken to avoid counting the benefit of
deductible tax losses twice in the assessment of the solvency
position of undertakings.
3.224.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.
3.225.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 including advice is set
out in Annex B.
c) Tier 2 requirements
Capital
instruments
3.226.List:
a. Called up ordinary share
capital
b. Other called up capital instruments that absorb losses
first or rank pari passu, in going concern, with capital
instruments that absorb losses first.
c. Other capital
instruments, including preference shares, that do not have the
conversion features required for Tier 1 but that display the
features below.
d. Other capital instruments, including
preference shares, not subject to write down as long as losses
persist, but that display the features below.
3.227.Tier 2 basic
own funds should display the following key features:
i.
Subordination: the item must be effectively subordinated in a
winding up.
ii. Loss absorbency: the item does not need to be
fully paid in, but can simply be called up, and must absorb
losses to some degree.
The undertaking must be able to defer
coupon payments once the SCR has been breached.
iii. 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.
iv. Free from requirements or
incentives to redeem: there may be moderate 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.
v. 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.
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
3.228.List:
No items.
C) Tier 3 requirements
Capital
instruments
3.229.List:
a. Other capital instruments,
including preference shares, that do not display the features
required for Tier 1 or Tier 2.
3.230.Tier 3 basic own funds
should possess at least some of the characteristics and
features required for Tier 1 and Tier 2 eligibility, but to a
lesser degree.
3.231.Tier 3 basic own funds should be
prevented from having characteristics and features that undermine
effective subordination.
• Tier 3 basic own funds should be free
from encumbrances.
• There should be no redemption of Tier 3
basic own funds, or coupon payments, on a breach of the SCR (i.e.
during the ladder of supervisory intervention), unless the
supervisory authority determines that redemption is necessary to
facilitate a recapitalisation.
• Tier 3 basic own funds should
have a minimum maturity (e.g. 3 years).
Other own fund
items
3.232.List:
Included in Tier 3 reserves are:
a. The
difference between the value of technical provisions calculated
in accordance with Articles 74 to 85, 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 in the case of
winding up with no transfer of portfolios.
b. Deferred tax
assets, (if not excluded from own funds) e classified in Tier
3
c. Expected future profits.
Ancillary own funds
a) Tier 2
requirements
3.233.List:
a. Ordinary share capital callable on
demand
b. Equivalent of ordinary share capital, callable on
demand, of mutual and mutual-type undertakings
c.
Supplementary member calls of mutual or mutual-type
undertakings, within the next twelve months, that can be made on
demand, where the call generates Tier 1 own funds and is clear of
encumbrances
d. Letters of credit and guarantees which are held
in trust for the benefit of insurance creditors by an independent
trustee and provided by credit institutions authorised in
accordance with Directive 2006/48/EC
e. Other capital
instruments, callable on demand, that absorb losses first or rank
pari passu, in going concern, with capital instruments that
absorb losses first
o Instruments that automatically convert
to ordinary share capital, or to the equivalent of ordinary share
capital of mutual and mutual-type undertakings, as and when the
undertaking needs to absorb losses, and in any case when the
undertaking breaches its Solvency Capital Requirement
o
Instruments subject to write down as long as losses persist, as
and when the undertaking needs to absorb losses, and in any case
when the undertaking breaches its Solvency Capital
Requirement
3.234.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.
3.235.Unless otherwise stated in the
Level 1 text, 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.
3.236.Classification
should be tested against the characteristics and features of the
Tier 1 item that arises through making the relevant claim.
b)
Tier 3 requirements
3.237.List:
a. Callable preference shares
classified in Tier 2 or Tier 3
b. Other callable capital
instruments classified in Tier 2 or Tier 3
Methods of supervisory
approval
3.238.Supervisory approval of the assessment and
classification requires supervisory judgment.
3.239.The
assessment process should be flexible enough to allow the
supervisory authority to consider market
innovations.
3.240.CEIOPS recommends that a mechanistic approach
be avoided to the extent possible. Supervisory approval should
take a principle-based approach.
3.241.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.
3.242.The
undertaking is responsible for verifying whether its own fund
items comply with the list and the required characteristics
envisaged in the implementing measures for the classification in
different tiers.
3.243.The (re)insurer assesses 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.
3.244.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);
• if the item is fully paid 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.
3.245.The supervisory
authority can always 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.
3.246.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
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 Solvency Capital Requirement and
the Minimum Capital Requirement.
3.247.CEIOPS recommends that
(re)insurance undertakings use a similar process when seeking
approval, as this would streamline the approval process.
3.248.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.
3.249.The approval is given for the item until its
legal maturity.
3.250.However, CEIOPS recommends that where the
characteristics and features of the item alter through a
contractual trigger, or through the restructuring of an item, the
(re)insurance undertaking submits a new request, and the
supervisory authority carries out a new assessment and grants a
new approval.
3.251.The procedures to be followed would be the
same as when an item is first submitted to the supervisory
authority for assessment and approval.
Cross sector
consistency
3.252.For alignment between the future insurance and
banking frameworks, consideration could be given to providing the
possibility in the implementing measures for evaluation and
review following implementation of Solvency II.
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