THE ANNEXES TO THE MINISTER'S LETTER
"Solvency II (Explanatory Memorandum 11978/07)
annex provides an update on the Government's views of the Solvency
II project in the light of the current global financial turmoil.
It gives information in particular in respect of attitudes towards
risk and suitable levels of capital. This annex sets out that
"The Solvency II Directive sets a calibration
standard for the main Solvency Capital Requirement which insurers
will have to meet on an on-going basis under Solvency II. This
standard is that an insurer should have no more than a One in
200 probability of failure over a one-year period. Subject to
meeting this standard, Solvency II allows insurers to adopt the
risk appetite which their board and senior managers determine
is appropriate as long as they have in place systems to manage
those risks effectively and of course adequate capital given the
chosen risk profile. This is in line with the current approach
adopted by the FSA and remains appropriate.
"It should be noted that any given capital requirement
imposed by the authorities is a minimum standard which in general
will be exceeded, often by a significant margin. The great majority
of firms will hold an additional buffer of capital for several
reasons. These include the desire to avoid regulatory intervention
subsequent to any capital shortfall against the regulatory minimum
and, for larger companies, to maintain a given credit rating.
"Further, the Solvency II Directive has two
capital requirements and when the lower of these, the Minimum
Capital Requirement, is breached, the insurer's authorisation
to write new business will be withdrawn. This should ensure that
well before an insurer's capital comes close to being depleted,
its existing policyholders are fully protected from the risks
inherent in writing new business. We expect that the Minimum Capital
Requirement will typically be in the range 20-50 per cent of the
main Solvency Capital Requirement. It is reasonable to expect
that companies will in general still have significant amounts
of capital at the point when they are prevented from undertaking
"Our conclusion is that the calibration standard
for the capital requirements under Solvency II remains appropriate.
"However we have also considered the issue of
the quality of capital which is eligible to meet those capital
requirements. In the European Commission's proposal for the Solvency
II Directive, the minimum amount of Tier One or highest quality
capital that a firm is required to maintain is one third of the
amount of the Solvency Capital Requirement. By way of comparison,
in the banking sector the equivalent requirement is that one half
of the minimum regulatory capital must be matched with eligible
Tier One capital.
"One key lesson emerging from the impacts of
the global financial turmoil is that financial companies require
high quality capital to maintain the confidence of counterparties
and other financial market participants, as well as of their policyholders.
At present in the UK insurance companies are required by the FSA
to hold at least half of the regulatory minimum capital requirement
in the form of Tier One capital. In practice in many firms the
share of Tier One in total capital held is significantly higher.
"Since the current FSA capital requirements
are calibrated to achieve a similar prudential standard to that
proposed for the Solvency Capital Requirement under Solvency II,
it follows that, on the basis of the current proposal, Solvency
II would permit a material dilution in the overall quality of
capital held by UK insurers.
"Of course it need not follow from the change
in regulatory requirements that insurance companies would necessarily
alter the share of Tier One capital in their total capital held.
Nevertheless, given the events of the past year the Government's
view is that it would not be appropriate to choose a lower minimum
for the amount of highest quality Tier One capital. We therefore
propose to advocate with the Presidency and other Member States
that under Solvency II insurance companies are required to maintain
Tier One capital equal to at least one half of the Solvency Capital
"The fourth Quantitative Impact Study
"The purpose of the fourth Quantitative Impact
Study (QIS 4) is to analyse the impact on insurance companies
of the proposed quantitative elements of the Solvency II framework.
At the time the specification of QIS 4 was developed by CEIOPS
and then agreed by the Commission late 2007 through to
early 2008 global financial markets had not yet experienced
the extraordinary disruptions we have recently witnessed. As a
result the specification of QIS 4 is of course consistent with
the Directive as proposed by the Commission but has not been altered
in the light of the recent events in global financial markets.
"Nevertheless, the Committee of European Insurance
and Occupational Pensions Supervisors (CEIOPS) has produced analysis
of the financial stability of the insurance sector at EU level,
including an assessment of its exposure to US sub-prime mortgage
risk either via holdings of Asset Backed Securities, or through
investment in hedge funds. The conclusion reached is that across
the exposures to this risk category is modest for the EU insurance
sector as a whole.
"Further, the fact that it was not possible
for QIS4 to reflect the implications for policy of the global
financial turmoil does not imply that that cannot be taken into
account in the Solvency II legislation.
"The Solvency II framework has the flexibility
to be adjusted to the lessons of the financial crisis once the
policy implications are fully analysed. As you are aware Solvency
II adopts the Lamfalussy arrangements for developing financial
services legislation. This means that the Directive currently
under negotiation provides a framework and core principles but
leaves considerable areas of the detailed technical legislation
for so-called 'level two' implementing measures.
"The Lamfalussy arrangements were deliberately
designed to achieve flexibility in EU financial services legislation
so that it could respond to significant changes in the financial
sector. This will allow lessons that are relevant to the insurance
sector to be applied in the detailed legislation of Solvency II.
However, we must avoid knee-jerk reactions to the current financial
problems and in particular we need to be careful to ensure that
the economics of the insurance sector, which is fundamentally
different from the economics of banking, is taken into account
fully where any read across between the sectors is envisaged.
"Along with other Member States' authorities,
HM Treasury and the FSA have a central interest in ensuring that
the level two implementing measures in Solvency II provide the
technical requirements to deliver a robust prudential framework
while also being proportionate in the regulatory burden imposed
"UCITS (Explanatory Memorandum 12149/08)
"This annex sets out further information on
the proposed reforms of the UCITS Directive, and in particular
information on developments on a management company passport following
the advice requested from the Committee of European Securities
Regulators (CESR) and for information on the views of UK consumers.
"On the former, CESR published its advice to
the Commission on 31 October.
This advice set out a framework which a majority of CESR members
believed would deliver the management company passport while maintaining
an appropriate level of investor protection and supervisory oversight.
The key points of this framework are:
the management company's home Member State should be the state
in which it has its registered office;
that the UCITS home Member State should
be the state in which the UCITS is authorised;
the depositary (the institution responsible
for safekeeping of the fund assets and some oversight of the management
company) should be located in the UCITS home Member State and
should have an information sharing agreement with the management
company to ensure ready access to necessary information;
where the management company is making
use of the passport, it should appoint the depositary or another
financial institution to act as a local point of contact in the
UCITS home Member State for the UCITS supervisor and investors;
that management companies using the passport
should be subject to the rules of their own home Member State
for matters relating to their general conduct as a management
company (for example conduct of business, risk management), but
that the rules of the UCITS home Member State should be observed
for matters relating directly to the operation of the specific
UCITS fund (for example investment policies and limits);
that supervisors should have the power
to conclude cooperation agreements in respect of their supervision
of UCITS managed by non-local management companies;
that the UCITS and the management company
should be subject to independent audits and that when the two
are audited by different auditors, those auditors should conclude
an information sharing agreement; and
that the UCITS supervisor should have
the power to take enforcement action for breaches of its rules
whether or not the UCITS is managed by a local management company.
"The Government believes CESR's advice represents
a good basis for the introduction of a management company passport.
The advice is broadly consistent with the proposals currently
being developed in Council working groups and the Presidency is
now going through the advice to consider where changes need to
"The main point on which the Council's proposal
may differ from CESR's advice is on CESR's proposal for a local
point of contact it is likely that the Council's position
will focus on ensuring that there are adequate procedures to allow
investors of a UCITS to make complaints about the management company,
even where that management company is not local. The balance of
opinion in the Council is that this is the key point for ensuring
investors' rights are protected and that the necessity for a local
point of contact for supervisors is adequately dealt with i) by
the provisions to allow UCITS supervisors to request a wide range
of information about the running of the fund; and ii) by the broad
provisions for cooperation between supervisors.
"Your second question was on the information
the Government has on the opinion of consumers. The area in which
consumer views are perhaps most important is on the proposed reforms
to the information provided to potential investors (to be known
as 'key investor information'). The Commission held workshops
with strong representation from consumer bodies when developing
its high-level proposals, and CESR has also consulted consumer
representatives in the course of developing advice to the Commission
on detailed rules on the form and content of this information.
The Commission is in the process of testing CESR's draft proposals
directly with consumers, and the results of that testing will
in turn inform the final version of CESR's advice. The Government
believes this will deliver a real improvement to consumer information
in the UCITS market.
"Concerning the other issues in the package,
it would be difficult to collect views directly from consumers
since these are largely technical amendments relating to the way
UCITS are run and do not substantially affect the nature of UCITS
as a product. However, in its response to the Commission's earlier
consultation on its proposals, the UK Financial Services Consumer
Panel agreed that
the UCITS review was "both timely and appropriate".
Of the consumer protection issues raised by the panel in its response,
the Government believes the large majority have been addressed.
Concerning the management company passport specifically, the Panel
expressed some concern about the potential for confusion around
the Commission's initial proposal for a "partial" passport
which would have allowed some activities to be passported but
not others. The Government shared this concern and believes it
will be addressed through the replacement of the partial passport
proposal with a full management company passport, backed up by
full and effective provisions for supervisory cooperation."
Capital Requirements Directive (Explanatory Memorandum
annex sets out how negotiations on the Capital Requirements Directive
are developing and gives a clarification of which outcomes the
Government desires and which aspects it wished to change.
"It sets out updates on negotiations and the
proposed timetable for completion. Firstly, on the timetable.
There is a high probability that the French Presidency will seek
to achieve a general approach among Member States at the December
meeting of Finance Ministers. While this timetable poses significant
challenges, especially in regard to the ongoing scrutiny process,
negotiations have progressed well in a number of areas.
"On the negotiations themselves, the proposal
covered four main areas:
large exposures regime: limits to ensure financial institutions
are not exposed too heavily to any single or connected counterparty;
The supervisory framework and supervisory
colleges: reinforcing the efficiency and effectiveness of supervision
of cross-border banking groups by formalising supervisory colleges
in legislation and requiring closer cooperation on the determining
of group capital levels;
The definition and limits on hybrid capital:
providing a common interpretation of the three main eligibility
criteria that correspond with 'higher quality' capital: permanence,
loss absorption and flexibility in payments, and establishing
harmonised quantitative limits for the extent to which hybrids
may be accepted as firms' original own funds; and
Securitisation and risk transfer activities:
revisions aimed at improving risk management by better aligning
potentially misaligned incentives, disclosure and diligence requirements
on the investor before they can invest and monitoring requirements
on an ongoing basis, alongside transparency requirements on originators
before they can sell.
"In terms of the large exposures regime, the
current approach sets a maximum limit for all exposures from banks
to non-banks and all interbank (bank to bank) exposures over one
year, but contains a national discretion on interbank exposures
for less than a year.
"So far in negotiations the main thrust of the
Commission's original proposal, to extend the current limit for
inter-bank exposures to all exposures regardless of maturity,
has been maintained. Further to this, our key negotiating objective,
that of ensuring a proportionate regime for the UK's smallest
banks and building societies, has also been maintained.
"The Government believes this will represent
a significant improvement to the stability of the financial sector
in the UK, decreasing the risk of large systemic linkages between
institutions. The original Commission proposal aimed to reinforce
the efficiency and effectiveness of supervision of cross-border
banking groups by formalising supervisory colleges in legislation.
It also required agreement between supervisors on entities in
the same group on issues for the whole banking group such as total
capital for the group, the distribution of capital across subsidiaries,
liquidity in subsidiaries and branches and reporting requirements,
and where agreement is not reached, a mediation mechanism was
proposed using CEBS
as an advisory body. Ultimately it was proposed that the consolidating
supervisor (that is the supervisor responsible for the parent
institution or holding company) would take the final decision.
"This approach would produce significant benefits
for cross-border banking groups, and potentially deliver more
efficient supervision and reduced burdens. The current draft of
the compromise text maintains this general approach, which the
UK has broadly supported. Furthermore, on the issue of determining
the total required capital for the group, the text now proposes
that the final decision on key supervisory issues shifts back
to the local supervisor. The Government believes this approach
strikes the right balance between efficiency of supervision and
the distribution of supervisory powers and responsibilities, and
will be seeking to ensure this option remains in the text, which
will allow the Financial Services Authority to remain ultimately
responsible for the capital levels of UK institutions.
"The Commission's original proposal on hybrid
capital was to introduce a common interpretation of the three
main eligibility criteria that correspond with 'higher quality'
capital: (permanence, loss absorption and flexibility in payments),
and establish harmonised quantitative limits for the extent to
which hybrids may be accepted as firms' original own funds has
largely been maintained. Subject to some modifications to ensure
that instruments issued by mutuals (who cannot issue pure equity)
can, in some circumstances, be deemed as comparable to equity,
this is an approach the Government continues to support, and one
that will bring significant benefits to cross border financial
"Finally, the Commission has proposed revisions
aimed at improving risk management by better aligning potentially
misaligned incentives, specifically by requiring investor institutions
in the EU to only invest in credit risk transfer products if the
originator has committed to holding a net economic interest of
at least five per cent. It has also proposed disclosure and diligence
requirements on the investor before they can invest and monitoring
requirements on an ongoing basis, alongside transparency requirements
on originators before they can sell.
"The Government initially had concerns over
the scope of the quantitative retention requirement, which would
effectively cover a wide range of instruments beyond simply securitised
assets. Negotiations are progressing well, and the scope is being
narrowed. This will help to ensure that the requirements reflect
a proportionate response to the financial market disruption. We
hope to see continued progress on further refining the scope as
negotiations proceed. In terms of the disclosure and diligence
requirements, the Government was supportive of these improvements,
but has agreed amendments to ensure they are workable in practice
and are less burdensome on the industry."