Omnibus II brings more clarity:
Transitional measures for own funds
Solvency Consulting Knowledge Series
Author
Dr. Manijeh McHugh
Contact
[email protected]
June 2014
After many years of negotiations,
the European Parliament adopted
the Omnibus II Directive on 11 March
2014. The agreement on Omnibus II
is the final step in the Level 1 political
process, and paves the way for the
intended introduction of Solvency II
on 1 January 2016.
With Solvency II now likelier than
ever to be implemented, undertakings need to prepare in order to allow
for a smooth transition from the current solvency regime to Solvency II.
The transitional measures1 will support this process. Apart from the
­topics risk-free interest rates and
technical provisions, they also cover
the treatment of outstanding hybrid
capital. All three areas may have a
signi­ficant impact on insurers’ solvency positions. This paper aims to
shed some light on the latter, i.e. the
rules for the treatment of hybrid
­capital issued before Solvency II
becomes effective, which are also
known as grandfathering rules. The
remainder of this paper is structured
as follows: First, we describe the
quantitative limits for eligible capital
within Solvency II. Secondly, we
explain the current status of the
­transitional rules. Finally, we discuss
open questions.
Eligibility of own funds –
quantitative limits
Solvency II distinguishes between
three classes of capital quality –
Tier 1, Tier 2 and Tier 3 – which in
sum constitute the risk-bearing
capacity of an undertaking.
Instruments classified as Tier 1
­capital have the highest quality,
i.e. ­Solvency II makes the highest
demands on these instruments, as
they rank after those classified as
Tier 2 or Tier 3 capital.2 In case of
insolvency, this means that assets
left after clearing all liabilities and
debt are used to pay Tier 3 capital
providers first, followed by Tier 2
capital providers. Tier 1 capital is the
last rank to be served and therefore
has the highest loss-absorbing
capacity.
According to draft delegated acts as
at March 20143, in conjunction with
the draft EIOPA Guidelines4 and as
illustrated in figure 1, solvency capital
requirements (SCR) have to be covered by at least 50% Tier 1 capital.
1
2
3
4
Omnibus II Directive, Articles 308b-d
For more information on the requirements
for the different tier classes, see
<http://www.munichre.com/site/corporate/
get/documents_E935242112/mr/assetpool.
shared/Documents/0_Corporate%20
Website/_Publications/302-08137_en.pdf>.
Delegated Acts are part of the Level 2 process.
EIOPA Guideline are part of the Level 3
process.
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Transitional measures for own funds
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The other half of the solvency capital
requirement may be covered with
Tier 2 and Tier 3 capital, with the
­eligibility of Tier 3 capital being
restricted to less than 15% of the solvency capital requirement. Minimum
capital requirements (MCR) have to
be covered by at least 80% Tier 1
capital.
Transitional rules
Prerequisites
Grandfathering period
The Omnibus II Directive comprises
the conditions for the qualification
of Tier 1 and Tier 2 basic own funds
under the transitional rules. Figure 2
provides an overview of the conditions and how they interact.
Excess capital, i.e. the part of own
funds that is larger than solvency
capital requirements and minimum
capital requirements, has to be of the
highest quality.
Most importantly in the context of
this paper, eligible Tier 1 capital may
consist of instruments with a hybrid
character if Tier 1 requirements are
met. The share of hybrid Tier 1 capital is restricted to 20% of eligible Tier
1 capital, and includes hybrids that
qualify as transitional Tier 1 capital.
Under the Omnibus II Directive,
the grandfathering period for the
inclusion of basic own fund items
as Tier 1 and Tier 2 capital will start
on 1 January 2016, and will last for
ten years at most. After this transitional period, i. e. by 2026 at the
latest, these instruments will lose
their entire risk-bearing capacity.
This means that they can no longer
be accounted for as eligible capital. Note that there is still a certain
degree of uncertainty regarding the
grandfathering period, since it is
explicitly stated to be a maximum
period.5
5
The wording in the Omnibus II Directive
is ’up to 10 years after 1 January 2016’.
Figure 1: Eligibility of own funds and hybrid capital
Own funds
SCR
Thereof hybrid
capital
Tier 1
Basic
own funds
MCR
Thereof hybrid
capital
Tier 1
≥50%
≤20%
≥80%
Tier 2
≤20%
≤50%
<15%
Tier 3
≤20%
Tier 2
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Date of issue:
legislative acts’6 and enter into force
after being published in the Official
Journal of the European Union.
Only instruments that were issued
before the earlier of
−−the date at which Solvency II enters
into force – currently expected to
be 1 January 2016, or
−−the date at which the delegated
acts (Level 2) enter into force
qualify as Tier 1 or Tier 2 basic own
funds for the transitional period.
Should the introduction of Solvency II
be postponed for some reason – which
we think is highly unlikely – the new
target date will replace 1 January 2016.
The delegated acts are ‘non-legislative
acts of general scope and application
to amend or supplement certain nonessential elements of
Eligibility under Solvency I
The Omnibus II Directive only allows
for those instruments which also
meet the Solvency I eligibility conditions to be relevant for transitional
agreements on Tier 1 and Tier 2 basic
own funds.
According to the current rules,7
certain instruments (‘hybrid capital’)
may contribute to up to 50% of the
available or required solvency margin, whichever is the lower. However,
only half of the respective capital,
i.e. up to 25% of the available or
required solvency margin, may have
a fixed maturity.8
Solvency II will allow for instruments
that pass the 50% rule to be classified as transitional Tier 1 capital.
Those instruments that due to their
fixed term structure fall within the
25% sublimit qualify as transitional
Tier 2 capital.9
6
7
8
9
Treaty of Lisbon, Article 249 B (1).
Reference is made to Article 1(3) of Directive
2002/13/EC in conjunction with Article 16(3)
of Directive 73/239/EEC, Article 27(3) of
Directive 2002/83/EC, and Article 36(3) of
Directive 2005/68/EC.
For subordinated loan capital in particular,
there are further conditions to be met. For
more information, see Article 1(3) of Directive
2002/13/EC.
Both classifications are subject to all other
Solvency I requirements being met.
Figure 2: Conditions for transitional Tier 1 and Tier 2 basic own funds
Transitional measures for
basic own funds do not apply
Non-compliance with
50% / 25% rule
Compliance with 50% rule
Compliance with 25% rule
Does not qualify as transitional
capital
Transitional Tier 2 capital
Qualifies as Solvency II
Tier 1 or Tier 2 capital
Does not qualify as Solvency II
Tier 1 or Tier 2 capital
Does not qualify as transitional
capital
Transitional Tier 1 capital
Eligibility under
Solvency I
After 1 January 2016 or date
of delegated acts entry into force
Non-classification
as Solvency II Tier 1
or Tier 2 capital
Prior to 1 January 2016 and date of
delegated acts entry into force
Date of issue
Date of issue
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Non-classification as Tier 1
or Tier 2 capital in Solvency II
Conclusion
The last condition set by the Omnibus II Directive refers only to those
instruments which aim to be classified as transitional Tier 1 basic own
fund item. Instruments which meet
the Solvency II criteria for classification as ‘ordinary’ Tier 1 and Tier 2
basic own fund items10 are excluded
from the transitional agreement.
This condition prevents instruments
that only meet the criteria for Solvency II Tier 2 own fund items to be
accounted for as transitional Tier 1
basic own fund items. As mentioned
above, this condition only applies for
classification as transitional Tier 1
capital. We understand that the condition would be redundant in case of
transitional Tier 2 capital. Undertakings which issued instruments that
qualify as Solvency II-compliant
Tier 1 or Tier 2 capital prior to the
date at which Solvency II or delegated acts come into force do not
have an incentive to classify these as
transitional Tier 2 capital, as this
would restrict the eligibility of these
own fund items to a maximum of ten
years without any consideration.
The transitional measures provide
the basis for a smooth change
between the regulatory regimes.
Based on our understanding of the
respective articles, some interesting
questions arise.
First, if we interpreted the articles
correctly, instruments that do not
qualify as Solvency II Tier 1 or Tier 2
capital may be classified as transitional Tier 1 capital if they are
­perpetual and fulfil the other criteria
described above, i.e. the date of issue
and Solvency I requirements. This
means that during the transitional
period the ranking of capital classes
does not necessarily reflect the
­quality of those. To be more precise,
instruments that qualify as transitional Tier 1 capital might be of a
lower quality in terms of loss absorbency than Solvency II compliant
Tier 2 capital. Therefore, the analysis
of an undertaking’s capitalisation
requires special care during the transitional period as two different sets
of criteria for transitional capital and
Solvency II capital are applied.
Secondly, assume an undertaking
that does not comply with solvency
capital requirements. According to
draft EIOPA Guidelines, redemptions
of Solvency II basic own fund items
are suspended for the undertaking
due to non-compliance with solvency
capital requirements. To our understanding, the applicability of suspension of redemption for transitional
capital in case of non-compliance
with solvency capital requirements
is not clear yet. We assume, however,
that this subject will be discussed
in the course of the political process.
So far, this paper only accounts for
an increase of own funds as means
of maintaining or restoring the solvency position. However, this target
can also be achieved by using other
instruments – including reinsurance
– in order to create capital relief.
For more information on how reinsurance can serve as a capital management tool, please see our knowledge
series ‘Reinsurance in capital management’.11
Munich Re assists its clients and enhances
the efficiency and effectiveness of their
risk management with broad portfolio
diversification and attractive reinsurance
solutions. Solvency Consulting has a
wealth of experience in dealing with the
standard formula, in addition to developing
and using internal stochastic risk models
and linking them to value based portfolio
management. We also play an active role
in industry committees looking at regulation and specialist issues and ensure that
knowledge and expertise are transferred
and translated into practical recommendations for action on the ground. We are thus
able to offer our clients real and effective
help in preparing for Solvency II.
10
11
Omnibus II Directive, Article 94
See <http://www.munichre.com/site/corporate/get/documents_E935242112/mr/assetpool.shared/Documents/0_Corporate%20
Website/_Publications/302-08137_en.pdf>.
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