New own funds specifications add capital restrictions

New technical specifications on Solvency II’s capital requirements make some significant changes to the way insurers calculate their own funds, but they also leave some unanswered questions. Louie Woodall reports

In October the European Insurance and Occupational Pensions Authority (Eiopa) released updated technical specifications for Solvency II valuation and Solvency Capital Requirement (SCR) calculations.

Many of the changes bring the specifications in line with the draft level 2 implementing measures that were produced by the European Commission in October 2011. However, in relation to the calculation of an insurer’s own funds, the specifications have gone beyond the draft level 2 text.

The new specifications raise a number of key issues for insurers in relation to own funds. First and foremost, they provide a stricter classification of eligible capital instruments than many predicted. The organisation of own funds capital into tiers has been tightened up and existing restrictions on top-quality instruments enhanced and formalised.

Second, the specifications raise questions about the benefits insurers will receive from expected profits included in future premiums (EPIFP) because of the definition of contract boundaries, a rule that limits the amount of expected future profits that can be counted as regulatory capital. Eiopa’s report on the fifth quantitative impact study (QIS 5) noted that “the different interpretations of the contract boundaries definition have led to inconsistency between undertakings and may also have led to incorrect calculation of technical provisions”. The updated specifications do more to muddy the waters, not less.

Finally, the extent of transitional measures for instruments that fall outside the own-funds tiering structure has not been clarified. While some grandfathering arrangements are expected to be incorporated in the final level 2 text for hybrid and subordinated  debt, insurers are still concerned that the transitional arrangements will be too restrictive.  

Until now the definition of own funds – the capital insurers have to meet their regulatory requirements – stem from last year’s draft level 2 text, and the technical specifications developed for QIS 5.

Eiopa insists that the updated specifications do not represent the final requirements that will feature in the completed level 2 text,  stressing that this specification, the first of two parts, is intended to be used for future quantitative assessments. However, insurance industry experts say they do provide a good indication of the authority’s current thinking on the rules and are a much-needed refreshment of the specifications since QIS 5.

David Dullaway, a London-based partner at consultancy Oliver Wyman’s insurance practice, says: “For the sort of things that are covered here in the technical specifications, we don’t have political interference [in the rule-making], so it is a good indication of where the rules will end up.”

Capital tiers
The division of capital into three tiers is a cornerstone of the own-funds methodology. Capital is classified by quality and loss absorption capability into three categories: Tiers I, II and III. Under the previous and updated technical specifications, 50% of a firm’s SCR has to be covered by Tier I instruments, such as paid-in ordinary share capital, initial funds, and EPIFP. Tiers II and III contain less robust items such as subordinated debt and hybrid capital of specific durations, and are permitted to cover the remaining 50% of the SCR, with some restrictions.

The updated specifications have complicated the classifications by introducing sub-limits within Tier I for ‘restricted’ and ‘unrestricted’ capital. Although present in a more nuanced form under the draft level 2 text, the updated technical specifications have made it a formal requirement for restricted items to make up no more than 20% of a firm’s Tier I capital.

These restricted items bridge the middle ground between those items that are most subordinated and fully paid up in Tier I and the less absorbent instruments in Tiers II and III, and include important varieties of hybrid debt, such as preference shares.

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