Ten things you need to know about Solvency II: Capital Instruments

1. Own Funds

UK insurers are required to hold a solvency margin or buffer to cover the risk of their assets not being sufficient to cover their liabilities. Under Solvency II the main capital requirement is the Solvency Capital Requirement (SCR).  There is also a lower Minimum Capital Requirement (MCR).  Under current FCA and PRA rules the margin held is known as ‘capital’. Under Solvency II, capital is called 'own funds' and divided into 'basic own funds' (e.g. on balance sheet amounts) and 'ancillary own funds' (such as letters of credit and guarantees) which require supervisory approval. It is expected that there will be some grandfathering or transitional arrangements but it is not yet clear what these might be or what conditions could apply to them.

2. Tiers of Own Funds

'Own funds' will be divided into 3 'tiers' based on both 'permanence' and 'loss absorbency' (tier 1 being the highest quality). Tier 1 is also divided into 'restricted' and 'unrestricted' tier 1. The rules impose limits on the amount of each tier that can be held to cover capital requirements with the aim of ensuring that the items will be available if needed to absorb any losses that might arise. This means that they need to be sufficient in amount, quality and liquidity to be available when the liabilities they are to cover arise. Items with a fixed duration, or a right to redeem early may not be available when needed. Similarly, obligations to pay distributions or interest will reduce the amount available to the insurer.  The rules on 'tiering' are designed to reflect the existence of such features.

3. Limits on Own Funds

Solvency II will set limits on the amount of tier 1, tier 2 and tier 3 own funds. Different limits apply for different purposes. The limits for own funds covering the minimum capital requirement, the MCR are the most restrictive. Ancillary own funds (i.e. requiring supervisory approval) cannot be used to cover the MCR and neither can tier 3 items. It is also expected that 80 per cent of the basic own funds used to cover the MCR will need to be tier 1 own funds. For the SCR, it is likely that 50 per cent of the own funds will need to be tier 1. It is also expected that at least 80 per cent of tier 1 items should be unrestricted tier 1 with no more than 20 per cent being restricted tier 1. Tier 2 can be up to 50 per cent and tier 3 can be no more than 15 per cent of eligible own funds. If a limit for one tier is exceeded the item may still be capable of being counted in a lower tier.  

4. Minimum Duration Requirements

An important difference between the current UK regulatory regime and the Solvency II rules will be the duration requirements applicable to each 'tier' in order to satisfy the permanence requirements. In high level terms, this is expected to equate to a 10 year minimum for tier 1 (i.e. earliest point at which it could be redeemed), a 5 year minimum for tier 2 and a 5 year minimum for tier 3. In addition, insurers will need to ensure that the duration of instruments is consistent with the average duration of their liabilities. This principle should form part of an insurer’s risk management policies and procedures.

5. Requirements for all capital instruments

Own funds items must be loss absorbing on both an ongoing and a winding up basis (i.e. there should be no features pre or on winding up which would prevent them being available). It is also a requirement that such instruments should not include terms which could cause or accelerate the insurer's insolvency.  EIOPA has given examples of features that could prevent own funds being available. They include terms in a capital instrument allowing the holder to require early repayment (e.g. if coupon is not paid) or which would enable the failure to pay amounts due to be treated as a liability for the purposes of establishing an insurer's insolvency or petitioning for the insurer's winding up.

It should also be noted that all own fund instruments should not:

• rank on insolvency before policyholder or non-subordinated creditors
• include encumbrances or connected transactions (e.g. guarantees or reciprocal financing arrangements)
• pay distributions/coupons whilst in breach of the SCR
• be redeemed without supervisory approval.

Supervisors may have a limited ability to waive suspension of payments where the item is being converted into an own funds item of the same quality and the MCR would not be breached.

6. What are Tier 1 items?

Tier 1 'own funds' include ordinary share capital, non-cumulative preference shares and relevant sub-ordinated liabilities. All distributions on tier 1 items must be cancelled in the event of a breach of the SCR and repayment of principal must be suspended. Preference shares and sub-ordinated debt will be subject to a new 'loss absorption' requirement (see 7 below) which could involve writing off all amounts owed by the insurer. Instruments which do not meet the tier 1 requirements on permanence or loss absorbency may still be categorised as tier 2 or tier 3 items.

EIOPA has also introduced the concept of unrestricted tier 1 own funds which must make up at least 80 per cent of total tier 1 funds. Unrestricted tier 1 will be made up of ordinary shares (ie those with full subordination) plus share premium and the equivalent paid up members contributions for mutuals. It will also include surplus funds meeting the full requirements for subordination and permanence and a ‘reconciliation reserve’. This will bring in an amount of implicit future profit (expected profit included in future premiums (EPIFP)). Unrestricted tier 1 items include paid in subordinated preference shares/members contribution and paid in subordinated liabilities. Ordinary shares which are senior to other ordinary shares will not be treated as ordinary shares for this purpose and will not count as unrestricted tier 1 items. However, if they are fully subordinated to policyholders and non-subordinated creditors and meet the other tier 1 requirements they could still qualify as restricted tier 1 items.

7. Loss Absorption Requirement

The new 'tier 1' loss absorption requirement will apply:

• where the insurer holds less than 75 per cent of its SCR;
• where it breaches its MCR; or
• where it breaches its SCR for more than 3 months.

The requirement is that there be an automatic writing down of the liability (principal and dividend/coupon), a conversion to ordinary shares or use of an 'equivalent mechanism' (i.e. to such writing down or conversion). It is not yet clear what will amount to an 'equivalent mechanism' for these purposes.

8. Tier 2

Tier 2 'own funds' are likely to include cumulative preference shares, and sub-ordinated liabilities with a shorter duration. Unlike tier 1 instruments, the principal need not be written down or converted following a serious breach of the solvency requirement (e.g. the 'loss absorption mechanism’ referred to in 7 above). Tier 2 may therefore also include shares or long term debt which does not comply with that requirement. All distributions/coupons on tier 2 own funds must be suspended following a breach of the SCR.  

9. Incentives to redeem

Tier 1 and tier 2 'own funds' can only be redeemed at the option of the insurer. Tier 1 items cannot include incentives to redeem that increase the likelihood to an insurer will redeem if it has the option to do so. This includes what are known as 'step-ups', namely where increases in the coupon make it likely that the instrument will be redeemed early by the insurer. Tier 2 own funds may include 'limited' incentives to redeem provided this does not happen in the first 10 years. Tier 3 instruments can only be redeemed at the option of the insurer after 5 years and may include ‘limited’ incentives to redeem. Incentives to deem that are not ‘limited’ are not permitted in any tier. All redemptions, conversions, repayments and exchanges will require the approval of the supervisor. 

10. Tier 3

Tier 3 own funds are intended (by the directive) to catch own funds which do not satisfy the tier 1 or tier 2 requirements but it appears (from the 5 year minimum duration), and the requirement for supervisory approval before redemption, that there may be other requirements for tier 3 instruments. Level 2 requirements are that tier 3 items must have an original maturity of at least 5 years and need only suspend distributions (not interest/coupons on debt) on breach of the MCR (and not the SCR). However, breach of the SCR would still trigger a suspension of repayment of principal amounts.