Explanatory Memorandum to COM(2000)634 - Amendment of Council Directive 73/239/EEC as regards the solvency margin requirements for non-life insurance undertakings - Main contents
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This page contains a limited version of this dossier in the EU Monitor.
| dossier | COM(2000)634 - Amendment of Council Directive 73/239/EEC as regards the solvency margin requirements for non-life insurance undertakings. |
|---|---|
| source | COM(2000)634  |
| date | 25-10-2000 |
A companion proposal to amend the solvency margin for life assurance undertakings has also been prepared. The two proposals have many common measures and for coherence should be read together.
Contents
- 1. Part A - General presentation
- 1.1. Introduction
- 1.2. Background
- 1.3. Some essential concepts
- 1.4. Summary of proposals
- 1.4.1. Minimum harmonisation
- 1.4.2. Indexation of MGF and premium/claims thresholds
- 1.4.3. Increased power of early intervention for supervisors
- 1.4.4. Changes to solvency margin for reinsurance
- 1.4.5. Class enhancement
- 1.4.6. Solvency margin requirement for run-off companies
- 1.4.7. Miscellaneous improvements
- 1.5. Future Commission action
- 1.6. Concluding remarks
- 2. Part B - Detailed commentary article by article
- This Article sets out the list of amendments to Directive 73/239/EEC
- This inserts a revised Article 16 (ASM)
- 2.3.3. Article 16a, (5)
- This inserts a revised Article 17
- 2.8. Article 2 - Transitional period
- 2.9. Article 3 - Transposition
- 2.10. Articles 4 and 5 - Entry into force and addressees
The Financial Services Action Plan, as endorsed by Heads of State and Government at the Cologne and Lisbon European Councils, stressed i the importance of the financial services sector as a motor for growth and job-creation. Users and suppliers of financial services should be able to exploit freely the commercial opportunities offered by a single financial market, while benefiting from a high level of consumer protection.
One of the most important regulatory instruments to protect consumers is the requirement for insurance undertakings to establish an adequate solvency margin. This fulfils a warning role and provides an additional buffer capital beyond that strictly required to cover policyholder liabilities. In adverse underwriting and investment conditions, undertakings have extra capital to protect policyholders' interests and this capital provides managers, supervisors and regulators with a breathing space to remedy difficulties.
The amendment of the solvency margin was included in the Financial Services Action Plan with a target date of mid-2000 for adoption of the proposal for the Directive.
The existing solvency margin requirements were established more than 20 years ago; in 1973 under the First Non-Life Directive i and in 1979 under the First Life Directive i. Since then they have remained substantially unchanged. In particular, the various minimum guarantee funds which correspond to the minimum regulatory capital required by an insurance undertaking have not been increased, notwithstanding the fact that there has been considerable claims and expense inflation in the intervening years.
This need to review to review the solvency margin requirements was already recognised at the time of the adoption of the Third Life and Non-Life Insurance Directives. However, in order not to delay matters, a provision i was established in each requiring the Commission to submit a report to the Insurance Committee on the need for further harmonisation of the solvency margin.
The essential conclusions of the Commission Report i were that:
- the simple, robust nature of the current system had proved satisfactory;
- the superiority of more sophisticated systems i had not yet been proved;
- scope for improvement existed;
- unnecessary additional cost for industry should be avoided.
This Commission Report was largely inspired by the Report on the Solvency of Insurance Undertakings prepared by the Conference of the Insurance Supervisory Authorities of the Member States of the European Union under the chairmanship of Dr Muller, the current President of the Bundesaufsichtsamt für das Versicherungswesen (Federal Insurance Supervisory Authority of Germany), the so-called Muller Report.
In the light of these two reports, the Commission has conducted an in-depth analysis with national experts of the solvency margin working group of the Insurance Committee over the last three years. Industry too has been closely involved and consulted. Extensive analysis and discussion has taken place and all this work has culminated in the present package of proposals.
The present proposal for a Directive significantly clarifies, simplifies, improves and updates the existing rules. Taken as a whole, it represents a significant strengthening and improvement of the current system.
For a proper comprehension of this Directive, it is necessary to clearly understand some essential concepts:
The required solvency margin (RSM): the amount of regulatory capital required by an insurer to write the insurance business for which authorised.
The available solvency margin (ASM): represents those capital items that may be used to meet the required solvency margin.
The guarantee fund: corresponds to a third of the required solvency margin. This is subject to an over-riding minimum - called the minimum guarantee fund (MGF). The capital items used to cover the guarantee fund requirement must be of a higher quality.
The proposals represent a package of measures (the so-called Solvency I package) which taken together significantly strengthen existing policyholder protection. They can be broadly sub-divided into the following themes:
The harmonised solvency margin (SM) rules are not to be considered strict: Member States are free to establish more stringent rules for the undertakings they authorise. In the past it was not clear whether the existing rules were to be considered strict or minimum. This lack of precision is now clearly removed by Recital i. This approach reflects differences between existing systems and allows national authorities to further strengthen RSM in line with their national market specificities.
The MGFs have been strengthened and indexed in line with inflation; so have the thresholds for the application of the split percentage rates for the premiums and claims. The number of MGFs has been simplified and reduced to two (from four). Generous transitional arrangements are foreseen (five plus additional two years from entry into force).
Regulatory supervision has been strengthened by expressly endowing the competent authorities with the power to take remedial action where policyholders interests are threatened. For example, if the financial position of an undertaking is deteriorating rapidly, the supervisory authorities may intervene even though the insurance undertaking may currently satisfy the RSM.
The existing formula for the reinsurance reduction to the RSM has been slightly improved. It is now based on a three-year average (as opposed to a single year). More significantly, supervisors are now empowered to reduce the amount of the reduction to the RSM where the nature or quality of the primary insurer's reinsurance arrangements is impaired or where there is no real risk transfer. The last item addresses the growing importance of financial reinsurance in today's market place.
A higher RSM is now established for non-life classes of business that have a particularly volatile risk profile. These are classes 11, 12 and 13 corresponding to marine, aviation and general liability. The proposal is to increase the current RSM by 50%. This proposal seeks to better match the amount of regulatory capital to the risk profile of the business.
Previously the RSM formula produced an unsatisfactory result for insurance undertakings in run-off. This is now corrected by requiring a proportionate run-down in the RSM.
The different items eligible for the ASM have been clarified and categorised into three groups according to their relative financial strength. Generally speaking, items from the first group are acceptable without limitation, items in the second group are subject to some limitation, while items from the third group are only acceptable with the approval of the national supervisor. The eligibility of certain items has been further limited, thus reinforcing the financial quality of the solvency margin. Furthermore, different accounting and actuarial approaches (e.g. book versus market values; discounting versus non-discounting of non-life technical provisions) are now treated in a more coherent and consistent manner.
The preparatory work for this draft Directive has clearly demonstrated that the RSM is but one of a series of parameters important to the determination of the overall financial position of an insurance undertaking. A true assessment must have regard not only to the SM of an insurance undertaking but also to other financial aspects:
- the adequacy of technical provisions;
- asset and investment risk;
- asset-liability management;
- reinsurance arrangements; and
- the accounting and actuarial methodologies.
Furthermore, there are other equally important non-financial issues such as the application of fit and proper criteria for management and the ability to make on-site inspections or supervise the operation of the insurance undertaking.
While the analysis has demonstrated the past adequacy of the existing SM regime, the future operating environment for insurance undertakings is likely be much more difficult for a variety of reasons. These include:
- tariff liberalisation as a result of the implementation of the third generation of life and non-life insurance Directives;
- the advent of the euro;
- merger and acquisition activity increasing the business pressure on smaller undertakings;
- shareholder pressure to reduce the free capital of an insurance undertaking to a minimum;
- new distribution channels and methods, such as the internet and direct writing, which will lower distribution costs and market entry barriers;
- reduced investment returns - it seems unlikely that the very favourable investment returns obtained over the last 20 years or so can be maintained at the current level.
These factors all point in the direction of increased competition and reduced free financial resources (i.e. less ASM) for insurance undertakings in the future. For this reason, it is intended to commence a fundamental review (Solvency II) of the overall financial position of an insurance undertaking, embracing all of the above factors as an integral part of the report on the application of this draft Directive as foreseen at Article 3 i.
However, in accordance with the political priority established by the Financial Services Action Plan, it is important to move forward and already implement the improvements described above. The Solvency II exercise will permit a longer term review of the wider picture taking into account all factors of financial stability.
Insurance is a risk business by definition. While no absolute guarantees can be given, every effort must be made to achieve the highest possible level of security. In this context, an adequate and appropriate level of solvency margin is a vital instrument to protect insurance policyholders everywhere. This Directive helps achieve this fundamental objective.
(Preliminary comment: references to existing Articles are shown in italics)
2.1. Article 1 - Point i - Small mutual associations
Point i: The current Directives do not apply to mutual associations where annual contribution income is below EUR 100 000. Point i raises this amount to EUR 5 million (idem for life).
There are many, small mutual associations which have a purely local or regional vocation and have no real need to be covered by the insurance Directives. Undertakings falling under the Directives have the benefit of the single passport. This means that they are entitled to market their products freely throughout the EU and that host country supervisors must accept the prudential supervision carried out by the home country authorities.
However, there is an obligation attached to this right and it is that passported undertakings are required to respect all the rules established by the Directives, in particular those applying to the RSM. Nevertheless, in order not to exclude small mutuals satisfying the RSM rules which wish to be covered, a new provision automatically entitles such mutuals to be covered upon simple notification to their competent authorities notwithstanding the fact that their contribution income is below EUR 5 million.
It should be noted that the proposed increase does not mean that such undertakings will be unable to write business in the future, only that they will not fall directly under the Directives. These undertakings will of course be subject to national prudential requirements as determined by the Member State concerned. These undertakings will therefore be able to continue to operate in the future under the direct supervision of their domestic authorities, but will not have a single passport i. Given that the vast majority have a purely local or regional vocation, this is in accord with the subsidiarity principle. Furthermore, as described under Article 2 of the proposed Directive, generous transitional arrangements are foreseen.
2.2. Article 1 - Point i - Available solvency margin
The revised Article restructures, clarifies and strengthens the existing definition of the items eligible for the ASM for non-life insurance undertakings. Article 16 i removes the anomaly in the previous definition with regard to the eligibility of certain items and specifically states that the RSM must now be satisfied at all times (merely than at the date of the last balance sheet).
Eligible items are divided into three groups of category: items under Article 16, point 2 are of the highest security and may be accepted without limitation, those under point 3 are subject to some limitations (e.g. preferential share capital, subordinated loans) while items under point 4, may only be accepted with the approval of the competent authorities.
The most significant improvements are:
Article 16(2)(c): The loss carried forward and dividends to be paid in respect of the last financial year are now deducted from the ASM; own shares are excluded (in the event of bankruptcy, their value is likely to be zero). Undertakings will also lose the benefit of discounting non-life technical provisions (cf comments below).
Article 16 i : No major changes.
Article 16(4)(b): The eligibility of supplementary contributions by members for mutuals will now only be accepted with the approval of the competent authorities (cf comments below). The eligibility of unpaid share capital or initial fund is limited to the lesser of 50% of the available and required solvency and will now only be accepted with the approval of the competent authorities.
The structure of the eligible items for the ASM for non-life is very similar to that for life business. In fact the two lists are identical except for five items as explained below.
The following items are only permitted in life assurance for technical reasons: profit reserves (Article 18(2)(d)), future profits (Article 18(4)(a)) and the adjustment for Zillmerising (Article 18(4)(b)). They are not permitted in non-life insurance and therefore do not appear in the list of eligible items for non-life insurance.
The two eligible items appearing in the non-life list but not in the life list are:
Article 16 i: This concerns the discounting of non-life technical provisions. This is only permitted under special circumstances as described in the Insurance Accounts Directive i. Undertakings discounting technical provisions are currently treated more favourably for SM purposes than those undertakings not discounting. The proposed paragraph disallows the benefit of discounting and therefore establishes parity of treatment between undertakings discounting and those not discounting.
The practical effect of the proposal is to strengthen the RSM for undertakings discounting technical provisions.
Article 16(4)(b): This concerns the eligibility of supplementary contributions by members for mutuals. This has always been accepted as an eligible item for SM purposes. Under the proposal, supplementary contributions will continue to be eligible, but this will now be subject to the approval of the competent authorities. This will mean that competent authorities will be able to assess the real likelihood of such supplementary contributions being available in the event of difficulty. This measure strengthens the RSM.
2.3. Article 1 - Point i - Required solvency margin
The formula for the RSM requirement in non-life business is different to that for life business. Whereas in life business it is based on the amount of the technical provisions, in non-life business it is calculated as the higher of two formulas; one based on premiums, the other based on claims.
A new Article 16a describing the RSM is inserted. There are three improvements to the RSM calculation. These are described below.
2.3.1. Article 16a,(3) first result, first paragraph and i, first paragraph
This introduces the class enhancement approach which is one of the most important proposals under the draft Directive. Class enhancement retains the simplicity of the existing methodology but for certain, more volatile classes of risk, the solvency margin requirement is increased or enhanced by a factor of 50%. These classes are 11, 12 and 13 corresponding respectively to aviation, marine and general liability. These classes are universally recognised as being more volatile in nature. The 50% enhancement is based on analysis by Member States and other technical input from the European Insurance Committee and the European Association of Actuaries.
2.3.2. Article 16a, i fifth paragraph and i sixth paragraph
The existing formula is calculated on a split rate basis. On the premium basis, this is 18% on the first EUR 10 million and 16% above; on the claims basis, this is 26% on the first EUR 7 million 23% above. The above paragraphs indexes the breakpoints in line with inflation to respectively EUR 50 and 35 million.
While the existing RSM has operated satisfactorily, because it is based on premiums and claims, it has a weakness where an undertaking starts to write a significantly lower volume of business. In the most extreme situation, that of an undertaking in run-off where no new business is being written, the formula can produce a zero RSM. This deficiency is corrected by requiring a minimum RSM based on the previous year's RSM reduced by the proportionate reduction in the level of technical provisions.
The advantage of this method is that for undertakings in run-off, the base level of the RSM is determined by the existing method, but that subsequently, the RSM is maintained at a level proportionate to the amount of the technical provisions remaining.
2.4. Article 1 - Point i - Guarantee Fund & MGF
Article 17 i: The rules governing the items eligible for the non-life MGF, follow that for life business, i.e. 100% of items must be drawn from the higher quality list subject but, as for non-life insurance, to establish parity between book and market value accounting, hidden reserves on the asset side may be accepted.
Article 17 i: The major difference between life and non-life is that for life business there is a single MGF whereas in non-life business this varies depending upon the class of business written. In the past there were 4 different amounts for the non-life MGF. This has now been simplified and reduced to two.
For classes 10 to 15, the new MGF is EUR 3 million. For all other classes, the MGF is EUR 2 million. This increase is largely justified by inflation in the level of claims and administration expenses incurred over the last 25 years or so. The increase is substantial and in fact goes some way beyond that strictly required by inflation alone. This is to reflect real increases in risk level and is in line with the proposals of the Muller Report.
Lastly, to help ease the capital burden of small mutuals, the Member State option granting a one-quarter reduction to the MGF for mutuals and mutual type associations, has been maintained.
2.5. Article 1 - Point i - Update procedure
This inserts a completely new Article 17a.
Article 17a i provides for the automatic update of the MGFs and the breakpoint for premium and claims SM percentages in line with EU consumer price inflation. It will strengthen the RSM in the future by maintaining the real level of these amounts. Had such a provision existed in the past, it would have avoided the need for the sharp increase in these amount at the present time.
To avoid needless small adjustments, indexation only takes place when there is at least a 5% increase.
Article 17a i: This is purely procedural and establishes an annual Commission obligation to communicate the adapted amount to the European Parliament and the Insurance Committee.
2.6. Article 1 - Point i - Minor technical amendment
This merely corrects a reference to the RSM to reflect the new Article 16a.
2.7. Article 1 - Point i - Power of early intervention by supervisors
This inserts a completely new Article 20a.
This is a completely new Article, expressly confirming the power of supervisors to intervene on a pro-active basis at an early stage. This need was also identified by the Muller Report.
Previously, when the financial position of an insurance undertaking was deteriorating rapidly, it was not clear whether supervisors had to wait until the ASM dipped below the RSM, before they could take action to protect policyholders' interests. This lack of clarity is removed by the present Article.
Article 20a i: This establishes a general power for the competent authorities to require an undertaking to submit a financial recovery plan where policyholders' rights are threatened. Elements for inclusion in the financial recovery plan are identified.
Article 20a i: This paragraph gives competent authorities the power to require a higher RSM in such types of situations.
Article 20a i: Markets are becoming increasingly volatile and significant changes in the market value of assets backing the solvency margin can occur. In order to be certain that the RSM is satisfied at all times, supervisors need power to be able to revalue downwards elements eligible for the ASM. This is vital where an undertaking relies on the full market value of assets and there has been a significant drop in such values since the last balance sheet date. This power is provided by the present paragraph.
Article 20a i: Reinsurance was an area identified by the Muller Report where supervisors needed to be able to take a more differentiated approach depending upon the quality and nature of the reinsurance programme. In particular, this was the case for financial reinsurance - where little or no real transfer of risk takes place. These issues are addressed by the present paragraph which allows supervisers to reduce the reinsurance reduction for the RSM in such circumstances.
This Article establishes a generous transition period for undertakings to conform with the new RSM. An initial transition period of five years is permitted which may be extended by a further two years. Given the time required for legislative approval of the present Directive, in all undertakings may have about eight to ten years to adapt to the new requirements.
This Article establishes the usual transposition provisions. Worthy of mention is Article 3 i which requires the Commission after three years 'to submit to the Insurance Committee a report on the application of this Directive and, if necessary, on the need for further harmonisation'. It is envisaged that this report will comment on progress achieved with the Solvency II exercise.
Self explanatory.