Structuring developments in Solvency II capital

Following the recent publication of the Technical Specifications in conjunction with the Stress Tests and the Implementing Technical Standards/Guidelines by EIOPA, we consolidate here the most recent developments in relation to own funds under the Solvency II framework.

Solvency II process and next steps

• The Omnibus II Directive, which updates the Solvency II Directive of 2009 (Level 1), was adopted in March by the European Parliament and subsequently approved by the Council of the EU in April. The Directive was published in the EU Official Journal on 22 May.
• The Commission’s Delegated Acts (Level 2) containing the implementing measures are not public but were reflected in the Solvency II Technical Specifications for the preparatory phase issued in conjunction with the Stress Tests 2014. The latest draft Level 2 text was released to the industry’s stakeholders in March. The European Commission is expected to formally present and publish the text in September. The European Parliament will then have up to six months to adopt or reject the text.
• Implementing Technical Standards and Guidelines (Level 3):

1. The first set of Implementing Technical Standards (ITS) was released on 1 April. Comments are due by 30 June 2014. EIOPA will submit the final version of the first set of ITS by 31 October 2014 to the Commission. It will have three months to adopt, amend or reject the ITS. If they are rejected, EIOPA will have six months to submit a new version. Once adopted, ITS will be published in the EU Official Journal and enter into force 20 days after.
2. The first set of Level 3 Guidelines was released on 2 June. Comments are due by 29 August 2014. Of note, the Guidelines relating to Pillar 1 contain a section on Own Funds that provides for a convergent application of the features for determining the classification of capital instrument set out in the draft implementing measures. Those guidelines can fall under the statutory framework and left outside of the terms of the bond.
3. A second set of ITS and Guidelines will be issued between December 2014 and March 2015.

Supervisory approval for the use of ancillary own fund items

• The ITS stipulate that an insurance or reinsurance undertaking shall submit a written application for approval of each ancillary own fund item specifying a monetary amount and compliance with own funds’ criteria. The supervisory authority shall decide on an application within three months (or six months under exceptional circumstances).

Common features of own fund items

• Guideline 13 clarifies that early redemption calls (e.g tax/regulatory/rating agency) are not allowed prior to five years from the date of issuance. However, substitution and variation language will be allowed (Guideline 5 1.29 mirrored by 1.42 and 1.50)
• The exchange or conversion (repayment or redemption) of an own fund item into (out of the proceeds of) another own fund item of at least the same quality shall not be deemed to be a repayment or redemption, subject to the approval of the supervisory authority.
• Dividend stoppers are not allowed in any own fund item.
• Incentives to redeem that are not limited and hence not compliant include:

1. Principal stock settlement/mandatory conversion/increase in the principal amount combined with a call option.
2. A change in the distribution structure from a fixed to a floating rate combined with a call option. This will probably be a major point of contention between EIOPA and issuers as the majority of transactions targeting direct Tier 2 Solvency II eligibility have used that coupon structure.
3. Other provisions that can reasonably be regarded as providing an economic basis for the likely redemption of the item (catch-all language).

• A moderate step-up is defined for Tier 2 and 3 as 100bp or 50% of the initial credit spread, less the swap spread between the initial index basis and the stepped-up index basis. The same wording can be found in the Basel II banking regulation. However, an example provided in the FSA Handbook (GENPRU 2.2.150) seems to indicate that this would not affect transactions priced versus mid-swaps and reset on a Euribor basis.
• Guideline 14 (exceptional waiver of suspension of redemption in the event there is non-compliance with the SCR, subject to compliance with the MCR) clarifies that the issuer should demonstrate how the exchange/conversion (in an item of at least the same quality) contributes to the restoration of the SCR and should not issue a new instrument to repay existing holders.
• Guideline 16 (exceptional waiver of cancellation or deferral of distributions) clarifies both the procedure for an exceptional waiver in respect of ACSM settlement (though the issue of new shares) and a (somewhat more blurred) application for an exceptional waiver of cancellation or deferral of distributions.
• Guideline 18 clarifies that an undertaking would have to submit the request for supervisory approval three months prior to the earlier of the proposed repayment or redemption date (or required contractual notice). Moreover, it would have to provide (1) the current and short-to-medium term impact on the undertaking’s overall solvency position and how the action is consistent with the undertaking’s medium-term capital management plan and its ORSA, and (2) the capacity to raise additional own funds if needed. Regulatory equity credit will be lost from the date of notice to holders or the date of supervisory approval if no notice is required.
• In the case of a request to redeem a capital instrument in years 5-10, Guideline 15 expands Art. 59 COF2 of the draft Level 2 rules and defines what the supervisory authority would assess to determine whether the margin over the SCR would be appropriate, notably based on the issuers’ current and projected solvency position, Own Risk & Solvency Assessment (ORSA), volatility of the SCR and access to capital markets.

Restricted Tier 1 items

• Undated, first call date not allowed to occur before five years. No incentive to redeem. Dividend pushers/stoppers not allowed.
• Suspension of repayment and cancellation of distributions in case of non-compliance with the SCR*. Distributions are paid out distributable items that are determined on the basis of individual accounts.
• Loss absorption in case of significant non-compliance with the SCR (possibility to insert additional triggers) defined as SCR<75% or non-compliance with MCR. The trigger point needs to be clearly defined in the T&C. The loss absorption mechanism is effective without delay.

1. In case of a conversion into equity, the T&C will have to specify either (1) the rate of conversion and the limit on the permitted amount or (2) a range within which the instrument will convert. Issuers should ensure that authorisations are in place.
2. In case of principal write-down structure, a write-up will be permitted only after the undertaking has achieved compliance with the SCR provided that (i) it is not activated by reference to own fund items issued or increased in order to restore compliance with the SCR and (ii) it occurs on the basis of profits which contribute to distributable items made subsequent to the restoration of compliance with the SCR.

Tier 2 items

• Minimum maturity of 10 years. First call date not allowed to occur before five years. A moderate step-up cannot occur before 10 years. Suspension of repayment and deferral of distribution in case of non-compliance with the SCR*.

Tier 3 items

• Minimum maturity of five years. Suspension of repayment in case of non-compliance with the SCR* and deferral of distribution in case of non-compliance with the MCR*.

*Subject to waiver

Grandfathering and eligibility of own funds instruments in the capital structure

• Grandfathering over 10 years. Cut-off date for the grandfathering of Solvency I format probably early 2015 (date of the adoption of the delegated acts). Non Solvency II-compliant perpetual bonds expected to be grandfathered in Tier 1.
• Compliance with the SCR: at least 50% of Tier 1 (of which max 20% of restricted Tier 1). Excess Tier 1 can be treated as Tier 2. Tier 2 and Tier 3 items < 50 % of the SCR (with Tier 3<15%).
• Compliance with the MCR: min. 80% Tier 1 (of which max 20% of restricted Tier 1). Max 20% Tier 2.