“The Standard Formula” host Robert Chaplin introduced the first in the podcast’s Back to Basics series, which will dissect the entirety of the Solvency II regime. In the series’ inaugural episode, Rob is joined by associate David Wang to explore all aspects of own funds, the Solvency II term for items that constitute an insurer’s regulatory capital.
This episode of “The Standard Formula” podcast launches the “Back to Basics” series, which will comprehensively cover the U.K.’s Solvency II regime. For the premiere episode, Skadden partner Rob Chaplin and associate David Wang delve into the intricacies of own funds, a core concept of Solvency II.
Own funds constitute an insurer's regulatory capital, comprising both balance sheet and limited off-balance sheet items. This discussion covers the three classification categories for own funds: Tier 1 (highest quality), Tier 2 (middle) and Tier 3 (broader spectrum and flexibility). Mr. Chaplin and Mr. Wang outline the specific requirements for each tier. Two characteristics of own funds fundamental to understanding them, namely permanent availability and subordination, are explored in detail.
The episode also includes a discussion of regulatory approvals and notifications and the implications of these concepts on the Lloyd's Insurance Market.
- “Own Funds” Basics. Own funds represent an insurer's regulatory capital, comprising balance sheet and off-balance sheet items. Insurers must hold own funds at least equal to the sum of their capital requirements, including the solvency capital requirement (SCR) and minimum capital requirement (MCR).
- Characteristics of Own Funds. Classification of own funds into tiers is determined by the degree to which they meet permanent availability and subordination criteria. Tier 1 capital: Stringent requirements apply, including non-redeemability for five years and discretionary dividends. Tier 2 capital: Standards are slightly relaxed. These are subordinated to all claims of policyholders and beneficiaries, must be dated at least 10 years and cannot be redeemed before five years after the date of issuance. Tier 3 capital: This represents the remainder of the balance sheet items subordinated after policyholder and beneficiary claims, with a five-year minimum maturity.
- Regulatory Safeguards of Ancillary Own Funds (AOF). Tier 2 and Tier 3 capital can tap into AOF — off-balance sheet items that insurers can use to absorb losses if necessary. They must involve legally binding obligations and be callable on demand. Inclusion of any AOF item requires regulatory approval, and such inclusions have typically been heavily scrutinized by the PRA. An insurer seeking approval must demonstrate to a high standard that the proposed AOF meets the regulatory criteria, including its legal binding nature, availability and reliability for absorbing losses.
From Skadden, the Standard Formula is a Solvency II podcast for UK and European insurance professionals. Join us as Skadden partner Robert Chaplin leads conversations with industry practitioners and explores Solvency II developments that matter to you.
Rob Chaplin (00:18):
Welcome to the Standard Formula podcast. I'm Rob Chaplin, one of the insurance partners at Skadden. I'm delighted to announce that we're launching a Back to Basics series, of which this is the first episode. The plan is, over time, to dissect and progressively cover the entirety of the Solvency II regime. These episodes will ultimately be compiled into a book, which will also cover the changes to the Solvency II regime as it evolves into Solvency UK. We'll release chapters of the book in advance to our mailing list as they get written. Existing listeners acquainted with our standard formula episodes will find these Solvency II discussions woven in on an ad hoc basis amongst our topical updates. Today we'll revisit one of the core concepts of Solvency II, owned funds. I'm delighted to be joined in this episode by my colleague, David Wang, who'll be helping us understand this subject. David, over to you.
David Wang (01:24):
Thanks, Rob. So owned funds is the Solvency II term for items that constitute the insurer's regulatory capital. These are principally balance sheet items, although there is a limited allowance for off-balance sheet items. The starting point is items most available to absorb losses, such as retained earnings, the proceeds of paid in ordinary share capital, or particular types of long-term debt instruments. Allowances also made for certain assets, which are less available to absorb losses and subject to certain eligibility criteria, may also extend to uncalled share capital and to other instruments such as deferred tax assets.
An insurer must hold owned funds at least equal to the sum of its capital requirements. Capital requirements are comprised, first, of the solvency capital requirement or SCR, and second, of the minimum capital requirement, or MCR, both of which we'll cover in another episode. These are not to be confused with an insurer's technical provisions, which are required to meet an insurer's obligations to policy holders as they fall due on a business as usual basis.
Equally, owned funds are not to be confused with the assets in which an insurer may invest, including with the proceeds of such owned fund items. Again, these are different concepts and regimes which will be covered in future episodes.
Following the UK's departure from the European Union, that's Brexit, on December 31st, 2020, the UK's divergence from EU derived rules is a tale of its own. The much storied divergence includes liberalization of the EU Solvency II regime. However, these changes do not, for now, include the area of owned funds, and we can expect the Prudential Regulation Authority, which is the UK's prudential regulator, to continue to follow the current Solvency II requirements in this regard for the foreseeable future. Our analysis today is therefore relevant to both UK and EU insurers, although here we focused on the UK. Rob, can you tell us about categories of owned funds?
Rob Chaplin (03:39):
Thanks, David. The starting point for owned funds is classification into categories. Insurers are required to classify owned funds into three categories with varying degrees of availability and subordination. Tier one is considered of the highest quality. Tier two sits in the middle, and tier three offers a broader spectrum and flexibility. Owned funds are further classified as either basic owned funds or ancillary owned funds. The former are on-balance sheet items. These qualify automatically and have a higher eligibility ranking. The latter are off-balance sheet items and require particular supervisory approval. We'll discuss approval later in the podcast. Once classified, insurers must ensure a certain balance and composition of owned funds, which David will cover further. David.
David Wang (04:37):
So the basic Solvency II regime is explicit about the balance and composition of owned funds. Tier one items must dominate the portfolio. These must constitute over one third of the total eligible owned funds for the SCR and over one half of the total for the MCR. Tier three items, however, must be minimized, constituting less than one third of the total eligible owned funds for the SCR. However, there's also secondary Solvency II legislation which imposes even stricter limits. This requires that tier one items cover least half of the SCR and 80% of the MCR. It further restricts tier three items to no more than 15% of the SCR. The secondary legislation also limits preference shares and other restricted items to 20% of the total amount of tier one items. Now that we've covered categories and composition, we'll walk you through the characteristics of owned funds. Rob?
Rob Chaplin (05:35):
Thanks David. Two characteristics of owned funds are fundamental to understanding them. These are permanent availability and subordination. The former, permanent availability, relates to how readily such owned funds can be mobilized to absorb losses. The second characteristic, subordination, refers to whether, and to what extent, the item is accessible to absorb losses. In a winding up, this prioritizes and protects policy holders and other similar beneficiaries. The greater the availability and subordination the better the capital from a regulatory perspective.
In making this assessment, insurers and regulators, in certain contexts, will need to evaluate the following four characteristics of the relevant capital item. First, the duration of the item. Second, the presence and impact of redemption pressures. These are requirements or incentives for the insurer to redeem. Third, the presence and impact of mandatory fixed charges such as interest payments. Fourth, the presence and impact of encumbrances. This includes rights of set-off, security charges, guarantees, restrictions, and the effect of a transaction or a group of connected transactions which have the same effect.
By way of illustration, if an insurer has insurance obligations that are long-term, it will correspondingly require capital that is reliably available over at least a matching time period. These owned fund items should not have restrictions or conditions that might unexpectedly deplete them. Thus, they will need to be stable, unencumbered, and without mandatory costs attached. This covers classification elements generally. David will now cover the particular characteristics that the regulation requires.
David Wang (07:35):
As discussed, tier one capital is the highest quality and must, therefore, meet the highest standards. There are stringent requirements for a proposed tier one item to meet. This includes the following. The item must have a permanent availability on a going concern basis and subordination after all other claims in a winding up. It therefore includes ordinary share. It may also include surplus funds, which are effectively profit, as well as a so-called reconciliation reserve, which is a flexible category that allows an insurer to take into account foreseeable dividends as well as expected profits in future premiums. And this may also include capital instruments such as certain types of subordinated debt. Any such tier one instrument must be undated and must not be redeemable before five years after the date of issuance. It must also now include any contractual obligation to be redeemed nor include any clauses or features which incentivize redemption.
Further, repayment or redemption of the instrument must be at the sole option of the insurer and subject to PRA approval including where the redemption is funded with the proceeds of a simultaneous issuance in replacement of qualifying instruments. Further, any dividend or coupon must be only repayable at the option of the insurer, meaning it's fully discretionary. The instrument must also permit the insurer to delay redemptions, dividends, and coupon payments for the duration of any breach of the SCR, and upon the breach of any of the SCR, any tier one preference shares must also be subject to a write-down in the principal amount or mandatory automatic conversion into ordinary shares.
As for tier two basic owned funds, the standards are slightly relaxed. Hence, any capital instrument must be subordinated after all claims of policy holders and beneficiaries, must be dated at least 10 years, but as with tier one, cannot be redeemed before five years after the date of issuance.
Tier two basic owned funds may, however, feature incentives to redeem, such as an interest step-ups after 10 years. Repayment or redemption must be at the sole discretion of the insurer and subject to PRA approval. Any dividend or coupon must be payable only at the option of the insurer, meaning again, that it is fully discretionary and, as of tier one, the instrument must permit the insurer to delay redemptions, dividends, coupon payments for the duration of any breach of the SCR.
As for tier three basic owned funds, this effectively represent the remainder of the balance sheet items subordinated after policy holder and beneficiary claims, and have a minimum maturity of five years. This means they can include a wider pool of assets, including deferred tax assets. So this covers basic owned funds. Rob, what can you tell us about ancillary owned funds?
Rob Chaplin (10:36):
Tier two and tier three capital can also tap into ancillary owned funds or AOF. These are off-balance sheet items which insurers can use to absorb losses if necessary. They must involve legally binding obligations and be callable on demand. Tier two AOF must perform like tier one basic owned funds when called up and paid in. As such, tier two AOF may include items like unpaid share capital, letters of credit, guarantees, and other legally binding commitments.
Tier three AOF may include items that fall short of these requirements, but subject to regulatory safeguards. Inclusion of any AOF item requires regulatory approval, and in our experience, such inclusions have typically been heavily scrutinized by the PRA. An insurer seeking approval must scrupulously demonstrate to a high standard that the proposed AOF meets the regulatory criteria, including its legal binding nature, availability, and reliability for absorbing losses. The PRA requires that the quantitative amount attributed to AOF items must be prudent, realistic, and reflective of the item's ability to absorb losses. It will provide approval for a specified monetary amount or a method to determine the amount of each AOF item for a predefined period. David, what about other regulatory approvals or notifications tied to owned funds?
David Wang (12:14):
Thanks, Rob. So there's two additional contexts where the PRA will expect to be informed or involved. The first is where the PRA is a group supervisor and the items is intended to cover the group's SCR. A firm can also request that the PRA makes an availability determination. This is a confirmation that the instrument meets the regulatory criteria for permanent availability and subordination.
Second, and with the exception of ordinary shares or any issuance of a class of a type previously approved by the PRA within last 12 months, the PRA will expect a minimum of one month notice prior to the inclusion of the item within basic owned funds. This notification must include, first, an independent legal opinion confirming that the instrument meets the applicable regulatory requirements, second, a draft of the terms and conditions for the instrument, and third, in the case of preference shares to be included in tier one, the notification must also include an independent accounting opinion. Rob, could you tell us how the above applies to the Lloyd's insurance market?
Rob Chaplin (13:19):
With pleasure, David. An interesting nuance arises with Lloyd's. Lloyd's itself largely complies with such requirements in its capacity as a quasi-insurance entity subject to prudential supervision by the PRA. Although an individual Lloyd's member or syndicate is not directly subject to the PRA's owned funds requirements, Lloyd's has elected to treat them as though they were. In this way, the traditional reliance by Lloyd's members on letters of credit, in some cases as to 100%, has been scaled back so that such letters of credit may not exceed 50% of a member's individual Lloyd's capital requirement, referred to as the economic capital assessment.
I think this covers about everything we had to say today. We'll continue to cover the nuanced fabric of regulatory mechanisms, such as owned funds, as the UK's regulatory rule set continues to navigate its post-Brexit financial regulatory waters. Please stay tuned for more episodes. If you have any questions at all on the topics discussed today, please don't hesitate to get in touch. We look forward to welcoming you next time.
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