August 17th, 2009

What does Solvency II Mean for Insurance Groups?

Posted at 1:01 AM ET

Financial Intelligence Team
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Introduction

When Solvency II becomes effective in 2012, group support — which would have allowed capital held at the group level to cover the requirements of any company in the group — will be not permitted. This prohibition will require group entities to hold capital according to the Solvency Capital Requirements (SCR) in each individual entity. The application of group-level diversification benefits to individual entities will not be allowed. This last-minute change to the original framework directive may cause some groups to change their structures. At a minimum, they are likely to rethink how much risk capital will be carried at the group level versus the operating entity level given that the risk capital needed in the group will increase without recognition of group support.

With regard to the SCR for groups, the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) included a new proposal for the assessment of group solvency in its series of Consultation Papers on Level 2 Implementing Measures for Solvency II. Consultation Paper 60 (July 2009) provides guidance on:

  • The definition of a group 
  • The calculation method for the SCR 
  • The inclusion of “third-country” carriers 
  • The eligible elements of group own funds 
  • The inclusion of group specific-risks when calculating the SCR

Definition of a Group

The definition of a group under Solvency II is principles-based and therefore fairly high level. The entities to be included in the calculation of a group’s SCR consist of “all parts of the group necessary to ensure a proper understanding of the group and the potential source of risks within the group.” Criteria such as “significant influence” and “dominant influence” will be considered in determining whether a company is part of a group; both criteria are explained more thoroughly in the draft advice. CEIOPS notes that significant and dominant influences are wider than the simple 20 percent/50 percent shareholders’ or members’ voting rights definition given in the underlying consolidation rules based on the Consolidated Accounts Directive. Thus, the scope of an insurance group from a regulatory perspective will be different from the scope used to consolidate financial accounts.

Group Solvency Calculation Method

Two methods are available for calculating the group SCR: the accounting consolidation-based method (”accounting method”) and the deduction and aggregation method (”aggregation method”).

The accounting method is based on a group’s consolidated accounts, which in Europe are primarily prepared according to International Financial Reporting Standards (IFRS). The group solvency margin is the difference between group own eligible funds and the SCR at group level calculated on the basis of consolidated data. Group diversification benefits are recognized. Under this approach, group internal transactions are eliminated, including group internal reinsurance contracts.

The aggregation method, on the other hand, compares the sum of the aggregated individual own funds within the group with the aggregated individual SCRs within the group. Some diversification benefits are already recognized in the individual SCR calculations, so additional diversification benefits at group level are not available. By design, intra-group reinsurance transactions are not eliminated using the aggregation method.

The accounting method is preferred by CEIOPS when assessing group solvency. It was already used in Quantitative Impact Study (QIS) 4 as the default approach tested and (unlike the aggregation method) considers the diversification benefits specific to the group level, such as geographical diversification. However, CEIOPS indicates that there will be situations in which the accounting method may be either suboptimal or inappropriate. In these circumstances, the aggregation method could be used instead. When dealing with specific group structures (e.g., those that have multiple entities outside the European Economic Area (EEA)), for example, the aggregation method may be more transparent — and thus more useful.

Inclusion of Third-Country Carriers

Third country carriers are those located outside the EEA. The primary issue related to third county carriers in the group calculation is the quality of the regulations governing them — e.g., capital adequacy requirements — and whether these rules could be considered equivalent to the Solvency II provisions. These rules will govern whether local third-country requirements or Solvency II requirements would apply when calculating the group SCR and group eligible own funds.

An important issue in this respect is whether diversification benefits from third-country entities can be taken into account. Issues restricting the recognition of diversification benefits of third countries include professional secrecy, access to information, and the fungibility and transferability of own funds. As such, equivalence does not guarantee that diversification benefits will be realized. Groups will also need to demonstrate the availability and quality of data from third countries.

Own Funds on Group Level

The group solvency assessment must be based on the overall capitalization of the group. In this respect, excess own funds above an individual SCR can compensate for an own funds shortage in other entities, as long as there are no local legal constraints on the capital. Therefore, both fungibility and transferability will be considered when calculating group eligible own funds. Fungibility refers to the ability to absorb losses of any kind within the group, as they are not dedicated to a specific purpose. Transferability denotes the ability of one entity to transfer assets to another.

A number of items that will be subject to restrictions when calculating eligible own funds are listed, including among others:

  • Reserves at the individual level subject to restricted availability (e.g., local statutory limitations)
  • Hybrid capital and subordinated liabilities
  • Ancillary own funds
  • Deferred tax assets

SCR — Group-Specific Risks

To reflect the total risk that an insurance group may face, the group SCR should reflect all quantifiable risks to which the group is exposed. In addition to calculating the group SCR, information on group-specific risks should be provided to supervisors — including reputation risk, contagion risk, the impact of intra-group transactions, and operational risk. The draft guidance implies that an additional capital requirement will have to be calculated for group-specific risks, but the exact allowance for these risks when the standard model is used is unclear.

Details are provided on how interest rate risk and currency risk should be treated on a group-wide basis, using consistent interest rate and exchange rate shocks across the group.

Conclusion

The changes coming with Solvency II involve more than the calculation of the SCR. In addition to optimizing the use of capital on an individual entity level, there may be a need to optimize group capital structure as well, particularly since the diversification advantages associated with group-level capital management will not be available.

Read other articles on Solvency II >>

Contributors

  • Susan Witcraft, Managing Director, Minneapolis
  • Frank Achtert, Managing Director, Munich
  • Iain Boyer, Managing Director, Norwalk
  • Michelle Harnick, Managing Director, New York
  • Dave Lightfoot, Managing Director, Seattle
  • Scott Lohman, Managing Director, Seattle
  • Don Mango, Managing Director, Morristown
  • Eddy Vanbeneden, Managing Director, Brussels
  • Jeff Bellmont, Senior Vice President, Minneapolis
  • Gina Carlson, Senior Vice President, Minneapolis
  • Debbie Griffin, Senior Vice President, New York
  • David Flandro, Senior Vice President, London
  • Benoît Butel, Vice President
  • Sebastien Portmann, Vice President, Zurich

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Statements concerning, tax, accounting, legal or regulatory matters should be understood to be general observations based solely on our experience as reinsurance brokers and risk consultants, and may not be relied upon as tax, accounting, legal or regulatory advice which we are not authorized to provide. To the extent that you discuss such statements with your clients, be sure to advise your clients that all such matters should be reviewed with their own qualified advisors in these areas.

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