In our fourth installment of “The Standard Formula” Back to Basics series, host Robert Chaplin is joined by Feargal Ryan for a detailed discussion on group supervision under Solvency II. Topics covered include circumstances when U.K. Prudential Regulation Authority rules on supervision apply to a group, methods for calculating group solvency and how own funds requirements operate at a group level.
This episode of the “The Standard Formula” podcast is the fourth in the “Back to Basics” series focusing on developments in the Solvency II regime. Skadden partner Rob Chaplin is joined by colleague Feargal Ryan to explore the complexities of group supervision under Solvency II.
Rob and Feargal begin with a discussion of the circumstances under which the U.K. Prudential Regulation Authority (PRA) rules on group supervision will apply to a group, followed by a look at methods for calculating group solvency. They also cover how own funds requirements operate at a group level, and conclude the discussion by considering the application of group supervision at group level under various scenarios.
Circumstances Where PRA Supervision Rules Will Apply to a Group. The PRA rulebook states that there are four scenarios where PRA rules on group supervision apply at a group level:
- an insurance carrier owns 20% or more votings rights or capital
- an insurance carrier has a parent undertaking that is an insurance holding company or a mixed financial holding company with its head office in the U.K.
- when the top company is an insurance holding company, a mixed financial holding company or a third country insurance or reinsurance carrier with its head office outside the U.K.
- a U.K. Solvency II insurance carrier has a parent company that is a mixed activity insurance holding company
- Classification of Own Fund for Purposes of the Group Solvency Calculations. Classification of own funds of U.K. Solvency II insurers will be classed in the same tier at the group level as at a solo level, provided certain conditions are met.
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 back to The Standard Formula podcast. Today we are continuing our Solvency II Back to Basics series, of which this is the fourth episode. We have thus far, as part of this series, covered own funds, reinsurance and risk transfer, and third country branches and cross-border provision of services. The Back to Basics episodes are being compiled into a book that will be released chapter by chapter, so please, if you have not done so already, sign up to our mailing list, as we'll be releasing chapters of the book to those on it.
Today we'll be talking about group supervision under Solvency II. I'm delighted to be joined by my colleague Feargal Ryan, who will help us explore the complexities of this topic. We will start by exploring the circumstances where the UK Prudential Regulation Authority, or PRA, rules on supervision will apply to a group before moving on to consider methods for calculating group solvency. We'll then consider how own funds requirements operate at a group level, before finishing by considering the application of group supervision at group level under various scenarios.
Feargal, why don't you start off by discussing the circumstances where rules on group supervision will apply at the level of a group.
Feargal Ryan (01:42):
Thanks very much, Rob. The PRA rule book states that there are four scenarios where PRA rules on group supervision apply at a group level. Scenario one is where a UK Solvency II insurance carrier owns directly or indirectly 20% or more voting rights or capital of, otherwise exercises significant influence over at least one other UK Solvency II insurance carrier or third country insurance or reinsurance carrier.
Scenario two occurs where a UK Solvency II insurance carrier has a parent undertaking that is an insurance holding company or a mixed financial holding company with its head office in the UK. An insurance holding company is a parent company that is not a UK Solvency II insurance carrier or a mixed financial holding company, whose main business is to acquire and hold what are referred to as participations in subsidiary undertakings, where subsidiary undertakings are either exclusively or mainly UK Solvency II or third country insurance and or reinsurance carriers or ancillary insurance service undertakings. And where such entities comprise more than 50% of two or more of, one, the parent companies consolidated assets, two, the parent undertaking's consolidated revenues, and three, the group solvency capital requirement as if calculated at the level of the parent undertaking. At least one of the parent company subsidiaries must be a UK Solvency II insurance carrier.
A mixed financial holding company is a company which, together with its subsidiaries, at least one of which is a regulated entity with its head office in the UK and other entities, constitutes a financial conglomerate as defined by the applicable rules. Both scenario one and scenario two groups are supervised pursuant to the rules set out in the Group Supervision section of the PRA Rulebook.
Scenario three occurs where the top company is an insurance holding company, a mixed financial holding company, or a third country insurance or reinsurance carrier with its head office outside the UK. Scenario four occurs where a UK Solvency II insurance carrier has a parent company that is a mixed activity insurance holding company. The extent of group supervision for scenario four groups is limited. It's become increasingly difficult to qualify as a mixed activity insurance holding company.
Another layer of complexity is that an insurance group can exist at multiple levels of a group structure. PRA group supervision rules will usually apply at the level of the ultimate UK Solvency II insurance carrier, UK insurance holding company, or UK mixed financial holding company in the group. If the ultimate holding company has its head office outside the UK, the applicable rules will depend on whether the jurisdiction in which the entity is incorporated is deemed to be equivalent to the UK.
For group supervision purposes and group solvency purposes only Switzerland, Bermuda and the member states of the European Union are deemed equivalent to the UK. However, it is important to note that no reciprocal determinations have been made by the European Union, which means that member states of the European Union cannot rely on group supervision exercised by the PRA in respect of European Union Solvency II groups that have an ultimate UK parent company. And European Union Solvency II groups with UK undertakings will need to calculate the contribution of those UK undertakings to group solvency, capital requirements and group-owned funds, on the basis of relevant European Union rules.
Rob, this is a good segue into our next topic, the calculation of group solvency.
Rob Chaplin (05:18):
Thank you, Feargal. Groups falling within scenarios one and two are required to calculate their group solvency in accordance with relevant provisions of the PRA Rulebook. In respect of scenario one, it's the UK Solvency II insurance carrier that is required to ensure that group solvency requirements are met. In respect of scenario two, where the group is headed by an insurance holding company or a mixed financial holding company, again, it's the UK Solvency II insurance carriers in the Solvency II group that are responsible for ensuring group solvency requirements are complied with.
There are two possible means of calculating group solvency. Method one, the accounting consolidation method, and method two, the deduction and aggregation method. While method one is the default, the PRA may allow method two or a combination of both to be used. The PRA must consider the following when assessing whether or not to allow the use of method two. Whether there is a sufficient amount and quality of information available in a particular instance to allow for the use of method one, would the use of method one be disproportionately burdensome. And whether the group includes non-UK entities that are equivalent, either provisionally or absolutely. In our experience, this most often occurs where overseas operations of a group located in a jurisdiction deemed equivalent for group solvency purposes use method two, either partially or exclusively.
Feargal, why don't you explain more about how group solvency is calculated under method one, accounting consolidation, and method two, deduction and aggregation.
Feargal Ryan (07:08):
Thanks, Rob. Method one group solvency is assessed by calculating the difference between own funds eligible to cover the solvency capital requirement at a group level and the group solvency capital requirement, which are both calculated on the basis of consolidated data. All related regulated and regulated undertakings in a group are included in the consolidation, but not all types of entities are included on a fully consolidated basis.
Undertakings not included in the scope of group supervision are excluded from the calculation. Consolidated data in respect of each group entity is included, save where necessary information in respect of an undertaking necessary to calculate group solvency is not available, then the book value of that entity must be deducted from the own funds eligible for the group solvency capital requirements. And the unrealized gains connected with the participation must not be recognized as own funds eligible for the group solvency capital requirements. And undertaking has been excluded from group supervision by the PRA where there are legal impediments to the transfer of information, or the relevant entity is a special purpose vehicle and certain relevant requirements have been complied with.
Basic principle is that method one uses consolidated data from all entities within the Solvency II group, and own funds is calculated as if the Solvency II group was one single insurer. However, among other things there is a proportional consolidation of data where members of the group share control of an entity with an entity outside the group, and the proportional share of a group entity's holdings in credit institutions, investment firms and UCITS management companies among others, are calculated on the basis of sector-specific rules.
Method two group solvency calculates the group solvency requirements based on the accounts of the solo entities. It is calculated by comparing the aggregated group eligible own funds on the one hand, and on the other hand the aggregated group solvency capital requirement plus the value in the participating undertaking of the related undertakings. The value of the related undertakings is added to avoid double counting between the value of those participations in the parent and the own funds of those undertakings in their contribution to group own funds.
The key differences between method one and method two are under method two, diversification benefits between group members are not recognized, but use of local rules is possible under method two for the calculation of group solvency, where the relevant non-UK entity is in an equivalent jurisdiction, at this time, Switzerland, Bermuda or a member state of the European Union. If a carrier within the group is in a non-equivalent jurisdiction, it's treated as if Solvency II rules apply to it for group solvency purposes.
Also, under method one, there's an additional test which sets a floor whereby the consolidated group solvency capital requirement must be at a minimum the sum of the minimum capital requirement, or MCR, of each insurance carrier in the group and the proportional share of the MCR of the related Solvency II undertakings. There is no comparable requirement for method two. This is because the deduction and aggregation method results in a solvency capital requirement that exceeds the sum of the MCR of each insurance carrier in the group, plus the proportional share of the MCRs of the related undertakings that are not wholly owned or controlled.
Rob, why don't you tell us about how own funds are classified for the purposes of the group sovereignty calculations?
Rob Chaplin (10:44):
Thank you, Feargal. Own funds of UK Solvency II insurers will be classed in the same tier at group level as at a solo level, provided that the item is free from any encumbrance or other arrangement that would prevent the item from being available at group level, and the own fund item must otherwise meet all relevant requirements, both on a group and solo basis. The item must be available to absorb losses once there is non-compliance with both solo and group solvency capital requirement. It's also important to note the own fund items that would be tier one on a solo basis, but for limits on preference shares and/or other subordinated liabilities can be included as tier one at a group level, provided that the relevant group level limits have not been exceeded.
Own funds of insurance holding companies, mixed financial holding companies, and ancillary service undertakings, must comply with the same criteria as own funds items of insurance carriers. The own funds of other entities included in the Solvency II group will be calculated as part of the reconciliation reserve at group level, which means that all such own funds would become Tier 1. Where such funds are material, they must be classed into tiers. In order to satisfy the PRA that own fund items are available to cover the group solvency capital requirement, it must be demonstrated that the item is available to absorb losses anywhere in the Solvency II group.
The PRA considers that a firm may demonstrate this by ensuring that each insurance carrier in the Solvency II group has the right to claim against the issuing entity if that insurance carrier is wound up and there is a shortfall for its policy holders. And also by subordinating the legal obligations of the issuing entity to the holders of the instruments, including the rights of holders to coupon payments, to any claims made by insurers in the Solvency II group that are being wound up. Regardless of whether method one or Method two is used to calculate group solvency requirements, own funder items must comply with the relevant Solvency II rules.
Feargal, you mentioned earlier that the supervision of groups that fall within scenario one and scenario two is governed by the Group Supervision section of the PRA Rulebook. Please would you explain a little more how that operates?
Feargal Ryan (13:28):
Thanks, Rob. Governance requirements imposed at a solo level are imposed in a similar way at the group level for scenario one and two groups. Risk management, internal control systems, and reporting procedures must be implemented consistently across all group entities within the scope of group supervision. Such internal control mechanisms must include adequate mechanisms as regards group solvency to identify and measure all material risks incurred appropriately relate eligible own funds to risks, as well as reporting and accounting practices sufficient to monitor risk concentration and intra-group transactions.
Scenario one and two groups are obliged to report to the PRA on a regular basis, and at least annually all significant intra-group transactions. Solvency II groups are obliged to prepare an annual Group Solvency and Financial Condition Report, as well as a solo Solvency and Financial Condition Report, or SFCR, for each UK Solvency II insurer in the Solvency II group. That Solvency II group may request that it only provide a single SFCR, comprising Solvency II group level information, as well as sufficient information for the entities in respect of which solo SFCR would otherwise be required.
For scenario three groups, it'll need to be considered how group supervision should be exercised. If the parent undertaking is in an equivalent jurisdiction, at present only Bermuda, Switzerland and the EU member states have been deemed equivalent for these purposes, then the PRA will rely on the group supervision provided by the relevant authority in that jurisdiction. Additional group supervision can be imposed at the level of the UK Solvency II subgroup, but where it would be more efficient and supervisory efforts are not harmed, then the PRA can exempt any UK subgroup from additional supervision. Where the jurisdiction of the third country parent undertaking is not equivalent, the PRA has the flexibility to choose whether to regulate the entire group, i.e. from the third country parent undertaking down, or if satisfactory, other methods can be agreed from the level of the top UK holding company down.
The PRA exercises this jurisdiction through the UK Solvency II insurance carriers authorization. The purpose of other methods is to ensure sufficiency of governance and prudential solvency at that lower level, and therefore other methods' structures will involve ensuring that the group, and in particular the constituent UK Solvency II insurance carriers, have proper staffing, boards, independence and access to capital when it is required. In practice, other methods' structures have become increasingly sophisticated and have achieved a balance between more effective supervisory oversight on the one hand and a structure that allows for more rational participation from capital providers and other participants in the economics of insurance businesses on the other.
For example, many international insurance businesses separate their Solvency II carrier group from the rest of the wider group's business. The US and the EU entered into a bilateral agreement in April 2018 on reinsurance group supervision, in respect of which the UK and the US entered into an equivalent agreement in 2018. A US reinsurance group is only subject to group supervision at the level of the parent undertaking in its home state, although the PRA is still empowered to supervise at a subgroup level.
Rob Chaplin (17:00):
That brings us to the end of what we have to say today. Thank you for joining us. We look forward to joining you for future episodes. Next time we will be discussing the matching adjustment. Please let us know if you have any questions or comments on what we discussed today or regarding Solvency II in general. Thank you and we hope you'll join us next time.
Thank you for joining us on The Standard Formula. If you enjoyed this conversation, be sure to subscribe in your favorite podcast app so you don't miss any future episodes. Additional information about Skadden can be found at skadden.com.
The Standard Formula is a podcast by Skadden, Arps, Slate, Meagher & Flom LLP and affiliates. Skadden is recognized for its deep experience in representing insurance and reinsurance companies and their advisors on a wide variety of transactional and regulatory matters. This podcast is provided for educational and informational purposes only and is not intended and should not be construed as legal advice. This podcast is considered advertising under applicable state laws.