Solvency II: Back on track, but hurdles remain

In November 2013, the Trilogue agreement on the Omnibus II Directive was welcomed by the market as it clearly paves the way for the implementation of Solvency II in 2016. By Michael Benyaya of Crédit Agricole CIB.

Michael Benyaya, CACIB

The agreement is undoubtedly a major step forward, but calibrations and technical details — notably in relation to the practical implementation of the long term guarantee package — are yet to be discussed and finalised in the Level 2 measures (Implementing Technical Standards).

The “long term guarantee” package buys time

The scope of the Omnibus II Directive was originally limited, but as time passed it drifted to address and soften the impact of Solvency II on certain insurance businesses. These discussions led to an agreement on the so-called “long term guarantees” (LTG) package included in Omnibus II, notably in relation to the following:

• Transitional arrangements for existing life insurance business to adjust to Solvency II over a period of 16 years. This will take the form of a gradual convergence towards Solvency II specifications of discounting rates and computation of technical liabilities.
• Matching adjustment to be applied to the discount rate used to value annuity-style liabilities.
• Volatility adjustment to be applied to the discount rate used to value all other businesses, in the form of two modules: one will be permanent by currency area, while the other will be automatically implemented at the national level in case of a crisis.
• “Provisional” third country equivalence for an initial period of 10 years followed by a review and potential extension, meaning that insurance companies headquartered in the EU will be allowed to use local solvency rules of “equivalent” jurisdictions when calculating the group solvency position.

The LTG package gives the industry time to adapt to the new Solvency rules, especially for smaller companies operating with high guarantee levels. Consolidation is nonetheless expected among the smaller players and in the mutual insurance sector.

Large insurance companies will also benefit from the LTG, but are not expected to raise capital to meet Solvency II requirements. However, their solid level preparation will certainly not prevent them from actively participating (and continuing their lobbying efforts) during the finalisation of the Level 2 measures.

EIOPA’s timeline for the delivery of Solvency II ITS and Guidelines

• ITS Set 1: Approval processes (public consultation April-June 2014)
• ITS Set 2: Pillar 1 (quantitative basis), Pillar 2 (qualitative requirements), Pillar 3 (enhanced reporting and disclosure) and supervisory transparency (public consultation December 2014 to March 2015)
• Guidelines Set 1: Guidelines relevant for approval processes, including Pillar 1 (quantitative basis) and internal models (public consultation June-September 2014)
• Guidelines Set 2: Guidelines relevant for Pillar 2 (qualitative requirements) and Pillar 3 (enhanced reporting and disclosure); public consultation December 2014 to March 2015

All eyes on the grandfathering rules

“Notwithstanding Article 94, basic own-fund items that (…) (c) would not otherwise be classified in Tier 1 or Tier 2 in accordance with Article 94 (…) shall be included in Tier 1 basic own funds for up to 10 years after 1 January 2016.”

This new provision inserted in Article 308b (grandfathering rules for instruments eligible to meet the Solvency I margin up to 50%) of the agreed Omnibus II text has stirred up the market. Indeed it suggests that an undated security structured to meet the Solvency II Tier 2 criteria will be directly classified in Tier 2 and not grandfathered in Tier 1. This goes against issuers’ initial expectations.

The first filter would hence be compliant with the Solvency II own funds criteria, regardless of treatment under Solvency I. Only if an instrument is not Solvency II-compliant will it then be treated as per the grandfathering rules.

It remains to be seen if and how this provision will affect the issuance format for subordinated securities. For example, would it possible to issue a Solvency I undated bond to target grandfathering in Tier 1? Only regulators know the answer, until the cut-off date (the earliest of January 2016 and the entry into force of level 2 measures on own funds) puts an end to any sort of speculation.

The main area of uncertainty is the treatment of old perpetual non-cumulative deeply subordinated bonds, which include a reference to a minimum Solvency Margin level which triggers the mandatory non-payment of interest. The classification of those bonds would primarily depend on the interpretation of this minimum level in the context of Solvency II: Does it refer to the Minimum Capital Requirement or the Solvency Capital Requirement (SCR)? If it is deemed consistent with the SCR, then such a bond could potentially be treated as eligible in the Tier 2 bucket. That said, those instruments were structured at a time when the Solvency II criteria were not available and hence could be grandfathered in Tier 1.

In any event, the current grandfathering rules should generally pose little risk to the total level of eligible capital of insurance companies. The size of the Tier 2 bucket under Solvency II (maximum 50% of the SCR) should generally be large enough to host all outstanding bonds.

Solvency II unlikely to lead to rating changes

In the same vein, the grandfathering rules are unlikely to affect the bonds’ eligibility in the Standard & Poor’s capital model, which will remain the primary measure of an insurer’s capital position in the S&P rating methodology (even under Solvency II). Although S&P has not reacted since the announcement of the Omnibus II agreement, the rating agency stated in the past (in the context of Basel III implementation) that a bond’s eligibility in Total Adjusted Capital (TAC) is ensured until the regulator removes it from regulatory capital (and if it also meets S&P’s criteria).

Moody’s and Fitch have not commented recently on the topic, but these rules should not change the rating agencies’ opinions on capital position.

More generally, the implementation of Solvency II is unlikely to trigger a wave of rating changes as the largest issuers have already anticipated well the requirements of the new Solvency regime.