Memorandum by the Financial Services Authority
1. The purpose of this note is to inform
the Committee about progress on the Solvency II Directive. It
complements the 7 August 2007 note submitted by HM Treasury which
set out the general background to this directive, its coverage
and the structure of its main requirements. This note provides
an update on key subsequent developments, including completion
of the third quantitative impact study (QIS3) undertaken by CEIOPS
(the Committee of European Insurance and Occupational Pensions
Supervisors: the relevant Lamfalussy Level 3 committee).
2. Negotiation of European legislation and,
ultimately, its implementation in the UK are responsibilities
of HM Government. The vehicle for implementing directives affecting
financial services is (for the most part) FSA rules. For this
reason we are working very closely with HM Treasury in the relevant
EU fora. Our work is guided by the objectives set out in the Financial
Services and Markets Act 2000 (FSMA): maintaining confidence in
the UK financial system; promoting public understanding of the
financial system; securing the appropriate degree of consumer
protection; and helping to reduce financial crime. FSMA requires
us to take into account the international character of financial
services and the UK's competitive position. We aim to promote
a well-regulated wholesale market which is efficient, orderly
and fair and to help retail consumers achieve a fair deal. We
focus on identifying and mitigating significant risks, taking
account of cost-effectiveness considerations and so not seeking
to eliminate all risk of failure within the financial system.
We see a progressive shift towards more principles-based regulation,
with correspondingly enhanced responsibilities for the senior
management of firms, as the preferred way forward for the long
3. The Solvency II Directive is intended
to promote a single market measure, but we expect it to make a
significant contribution towards mitigating risk. We have no statutory
objective to promote a European single market.
4. As outlined in HM Treasury's note, Solvency
II will be a Lamfalussy directive. The Commission's Proposal for
Level 1 text was published on 19 July 2007 (along with the Commission's
Impact Assessment) and discussions in the Council Working Group
started in September. We expect, based on the Commission's outline
timetable, that "political agreement" on Level 1 could
be reached in the second half of 2008 (though naturally, as this
is a negotiation, this is subject to some uncertainty). CEIOPS
has been asked to deliver its (final, fully consulted) advice
on Level 2 implementing measures to the Commission by October
2009. Negotiations on Level 2 may then be completed by late 2010.
The Commission's intended implementation date is October 2012.
5. For Solvency II, we support an appropriate
adaptation to insurers of the three-pillar structure of the 2004
Basel Framework for banks: pillar 1market-consistent valuation
standards for assets and liabilities, and risk-responsive capital
requirements to help address the risk of financial deterioration
in adverse circumstances; pillar 2supervisory review, including
increased focus on the quality of risk and capital management
in particular insurers; pillar 3regulatory reporting and
public disclosure. In many respects this would reflect the approach
that we have taken in our domestic insurance reforms (introduced
in 2004), including encouraging the development of liability and
capital modelling capability by insurance firms (Individual Capital
Adequacy Standards: ICAS). Accordingly, the Directive should serve
to underpin the modernised, risk-based and proportionate regime
that we now have in place in the UK. We believe it will promote
greater convergence of regulatory requirements and practices across
the EU, and bring greater cross-sector convergence. The Directive
provides a good opportunity to enhance the supervisory model for
insurance groups with subsidiaries in different Member States.
In order to help secure a proportionate directive we have provided
support to the Commission to produce a robust Impact Assessment
to accompany the Directive proposal. We intend to assist actively
with a further Impact Assessment to accompany the Level 2 proposals.
6. Under Pillar 1, firms will be required
to hold capital to at least the level of the Solvency Capital
Requirement (SCR)to mitigate the risks arising if the value
of a firm's assets falls, or its liabilities increase, under adverse
conditions. The SCR is to be calibrated at a 99.5% level of confidence
that the firm's assets remain sufficient to meet its liabilities,
over a one year time-horizon. (This is consistent with the corresponding
calibration of our ICAS regime). A firm could calculate the SCR
by "standard formula", or, subject to supervisory approval,
use its own capital model (the "internal model" approach).
Solvency 2 also sets a Minimum Capital Requirement (MCR), below
which level policyholders are considered to be at unacceptable
risk. A firm whose capital falls below the level of the MCR, and
which cannot restore capital in short order, would be closed to
new business. The MCR is intended to offer a regulatory intervention
point, so that, to the extent possible, a firm's book may be de-risked
and existing business run-off on a solvent basis, or transferred
to another firm.
7. CEIOPS conducted is latest Quantitative
Impact Study ("QIS 3") between April and July 2007.
Its report on the EEA-wide results of this exercise was publised
on 20 November. Simultaneously, a report on the UK results was
published on the FSA website. QIS 3 tested the suitability and
financial impact on firms of key aspects of the Commission's Level
1 text, along with CEIOPS' work-in-progress on the related Level
2 implementing measures. Key aspects tested were the proposed
requirements on: the valuation of technical provisions for liabilities
to policyholders; the implications for firms' capital ("own
funds"); the Minimum Capital Requirement (MCR) and the Solvency
Capital Requirement (SCR). In addition to quantitative returns,
firms were invited to complete a qualitative questionnaire, including
comments on practicability and resourcing implications. In the
UK, 39 life firms and 46 non-life firms (including Lloyd's of
London) participated, comprising 65% and 75% of the respective
markets by premium income. We believe sufficient small firms participated
to enable useful conclusions to be drawn about potential impacts
on them. 11 groups submitted group responses.
ENGAGING UK STAKEHOLDERS
8. We continue to devote much effort to
active engagement of UK stakeholders. Together with HM Treasury
we published two discussion papers in 2006: Solvency 2-a New Framework,
and Supervising Insurance Groups under Solvency 2. A further discussion
paper on supervision of insurance groups is being prepared. To
secure engagement on Solvency 2 at senior levels with the insurance
industry, there are quarterly meetings of a "High Level Group"
chaired by HMT on which the Managing Director of the FSA's Wholesale
Business Unit represents the FSA. Industry members include the
DG of the ABI, a representative of the Board for Actuarial Standards,
and the CEOs of a number of major insurance companies. The FSA
chairs an Insurance Standing Group, which acts as a pre-consultation
forum and more generally keeps the industry up to date on a monthly
basis with the progress of European discussions. Papers and minutes
of these meetings are published on the FSA website. To support
the UK execution of QISs, we have devoted resources to a number
of workshops for firms (often in liaison with the relevant trade
associations), operated a technical query service for participants,
and organised feedback sessions on the results. We have a full
speaking programme at relevent conferences.
IN CEIOPS (AND
9. The next 12 months and beyond will see
intensive activity in the Council Working Group (CWG) and, increasingly,
in the European Parliament as Level 1 negotiations progress; also
in CEIOPS as it draws up advice on Level 2 implementing measures
and conducts QIS 4. (CEIOPS' advice to the Commission on the specification
for QIS 4 is due by 20 December). We will continue to be active
in CEIOPS and have stepped-up the level of our support to HM Treasury
in the CWG. The FSA has one staff member on secondment to support
the CEIOPS' Secretariat, two others on secondment to the Insurance
Unit of the Commission, and one on secondment to the Secretariat
of the European Parliament's Committee on Economic and Monetary
10. Hector Sants as CEO of the FSA has succeeded
John Tiner as our Member of CEIOPS and has also been elected to
its Managing Board. CEIOPS' work on Solvency II is progressed
through a variety of expert groupswe chair the important
Internal Models Expert Group and are active participants in all
other relevant working groups. We are proactive in offering technical
briefings to MEPs.
SOLVENCY II AND
11. The Commission's draft Level 1 text
meets most of the UK objectives, crucially by requiring market-based
valuations of assets and liabilities and through application of
the "three-pillar" approach, similar to Basel 2. It
also gives a fair reflection of the UK proposal on group supervision.
However, results from QIS 3 for the UK, and the EEA more broadly,
suggest that some significant work is required (at Levels 1 and
2) on the structure and calibration of capital requirements. In
particular, the form and calibration of the Minimum Capital Requirement
(MCR) is a significant unresolved issue. In addition , alongside
HMT, we stand ready to defend key modernising features of the
proposed framework as necessary during Council Working Group discussions.
We have reservations about the possibility that the Level 2 provisions
could in some areas emerge as over-prescriptive and "maximum
harmonising". Superficially attractive from the (anti-) gold-plating
perspecive, such an approach could be dangerous in practice, fettering
supervisors' ability to deal with specific situations in an intelligent,
risk-based and timely way.
SOLVENCY II AND
QIS 3 RESULTS
12. The Commission's impact assessment of
the Level 1 text was published with the Level 1 Proposal in July.
We consider it was a marked improvement on previous Commission
impact work and was fit-for-purpose. It is very clear, however,
that the overall impact of Solvency II will depend heavily on
the outcome of the Level 2 negotiations, and so there will be
material uncertainties until those are concluded (prospectively
in late 2010). The Commission has committed to a full impact assessment
of Level 2 and is pressing CEIOPS to do the same in drawing-up
its advice. As well as capital costs, this should include an explicit
consideration of administrative expenses imposed on firms, for
example through reporting and disclosure requirements.
13. Our current "best-estimate"
of the impact of Solvency II is based on CEIOPS' QIS 3 study.
The UK results showed that CEIOPS' work on developing appropriate
Level 2 standards has progressed since QIS 2. But further work
is needed. In particular, QIS 3
(a) CEIOPS' preferred option of a "modular"
MCR does not work for life firms, giving a wide variance in ratios
of the MCR to SCR across firms. This would cause difficulties
to the operation of the "regulatory ladder of intervention"
in firms and to firms' capital planning;
(b) further progress is needed in refining
the "standard" SCR calculation, including to provide
a realistic calibration of the non-life underwriting risk component
and to remodel the policy lapse/surrender risk requirement for
life linked business;
(c) greater clarity was needed in the "own
funds" criteria for classifying different types of capital;
(d) the calibration of the equity risk stress
in the SCR is a major factor in determining the total capital
required by life insurers.
14. In CEIOPS, work continues on drawing
up a revised specification for the QIS 4, which is due to run
from April to July next year. There remains a wide range of views
on the structure of the MCR, and on calibration of the equity
risk stress in the SCR. While, technically, these are Level 2
details, feedback from the industry and other stakeholders during
the QIS 4 consultation period (planned to run through January
and into February 2008) will need to be wieghed carefully before
the specifications are finalised.
15. There are a number of different ways
in which the principle of proportionality will be built into Solvency
II for all firms, along with some specific small firms' adaptations.
Level 1 text requires that: "requirements of the directive
are applied in a manner which is proportionate to the nature,
scale and complexity of a firm's business"a principle
which spans all three pillars of the framework. Application of
this principle will need to be elaborated at Level 2, and CEIOPS
has been asked to develop a first tranche of advice on this topic
by May 2008. Very small insurers (the Proposal text suggests those
with annual premiums below EUR 5 million) will be excluded from
the scope of application of the directive (being subject instead
to national regulation).
16. In determining their required capital
(the SCR), firms will be able to choose between using an internal
model (subject to supervisor approval that it meets the necessary
standars) or the "standard formula". Indeed, firms may
choose to model their more material risks, but apply the more
simple standard approach to lesser risks, or lines of businessa
feature that may be particularly helpful to niche non-life firms.
Within the standard approach, too, there are some options: smaller
firms with simple risk profiles will have access to some simplifications.
QIS 4 should see the first systematic testing of the simplifications
available for small firms.
17. Naturally, as the project advances,
and in particular once Level 2 standards are more developed, the
FSA will increase activity aimed at helping to ensure that UK
firms are well-prepared for implementation of Solvency II. We
have begun discussions with the ABI, on planning the process for
FSA review and approval of firms' internal models (where they
wish to use them). This will build on and carry forward our routine
ICAS (current domestic standards) review work. In dialogue with
the industry, and drawing on our experience with implementation
of the Capital Requirements Directive, we aim to develop arrangements
(a) ensure that Level 2 standards for internal
models are developed in a manner which builds upon, and does not
conflict with, industry best practice;
(b) ensure that UK firms are well-placed
to understand the likely practical interpretation of Level 2 standards
as they emerge, and application processes and deadlines, so that
they can prepare and achieve approval to use their internal models
from "day 2"; and
(c) ensure that FSA has a good understanding
of the number of firms that are likely to seek internal model
approval, aiding our planning and resourcing.
10 See Annex 1 for a high-level summary of QIS 3 results
for UK firms. Back