SUBJECT MATTER

  The proposed Solvency II Directive (COM (2007) 361), published by the European Commission on 19 July, is a wide-ranging revision of the prudential regulation of insurance and reinsurance companies operating in the EU. The project has four main objectives:

—  Deepen the single market for insurance and reinsurance;

—  Enhance policyholder protection;

—  Improve the international competitiveness of EU insurers and reinsurers; and

—  Improve insurance and reinsurance regulation to further the European Commission's Better Regulation agenda.

  The Directive is based on a 3-pillar approach similar to that used in the Basel II banking accord:

—  Pillar 1 covers principles for the valuation of insurers' assets and liabilities, in particular the liabilities to their policyholders. It also sets capital requirements and defines what kinds of capital are eligible to meet those requirements. Pillar 1 provides for a harmonised standard formula for insurers and reinsurers to use in calculating their capital requirements, and subject to supervisory approval, allows the use of insurers' own internal models to calculate the main capital requirement which Solvency II will impose.

—  Pillar 2 defines qualitative requirements that insurers and reinsurers will be required to meet as part of the process of supervisory review of their business by regulators. All firms regulated by the Directive will be required to undertake an assessment of the risks to their business, the adequacy of their capital resources and to determine the appropriateness of their internal governance.

—  Pillar 3 sets out requirements on disclosure of information that firms will have to release both to regulators and publicly. Insurers and reinsurers will be required to produce annually a public report which will include information on capital and risk management.

  The Directive specifies the above requirements for insurance and reinsurance companies, and also includes provisions for the supervision of insurance and reinsurance groups.

MINISTERIAL RESPONSIBILITY

  The Chancellor of the Exchequer has responsibility for United Kingdom policy on financial services. The field of financial services is a reserved matter.

LEGAL AND PROCEDURAL ISSUES

(i)  Legal basis

  The legal base of the Directive is Articles 47(2) and 55 of the EC Treaty. Article 47(2) concerns freedom of establishment, in particular, by making it easier for persons to take up and pursue activities by issuing directives for the coordination of laws, regulations and administrative actions in Member States. Article 55 applies the same provision in relation to the freedom to provide cross-border services (ie where the undertaking does not have a permanent physical presence in the Member State into which it is providing services).

  The Directive incorporates and amends the 13 existing EU Insurance Directives which relate to prudential supervision (including in particular the key Non-life and Life Insurance Directives[1], the Insurers Reorganisation and Winding up directive,[2] the Reinsurance Directive[3] and the Insurance Groups Directive[4]).

  The Directive utilises the Lamfalussy arrangements for developing EU-wide legislation for the financial services sector. The Commission's proposal, published on 19 July, is the Level 1 framework Directive and as such sets out high-level principles and the requirements that constitute the core of the new prudential framework. The Directive gives the Commission the power to develop Level 2 implementing measures (ie Commission Regulations or Directives) which will specify the technical detail of the framework.

(ii)  European Parliament procedure

  The articles referred to above which provide the legal basis of the Directive require the co-decision procedure to be followed in Article 251 of the EC Treaty.

(iii)  Voting procedure

  The voting procedure in the Council on this directive with be qualified majority voting.

(iv)  Impact on United Kingdom Law

  The Directive will need to be implemented in UK law. The present directives are implemented in the Financial Services and Markets Act 2000 (FSMA), which applies throughout the UK, and in the rules of the Financial Services Authority, which are made under the provisions of FSMA. The Directive will require changes to be made to the regulation of insurers and reinsurers in the UK. Most of the rules concerning the prudential requirements on insurers and reinsurers are in the FSA's Handbook, which will need to be amended accordingly. Aspects of the Directive might also require amendments to be made to FSMA and to its secondary legislation; we would expect such changes to be made predominantly by regulations made under section 2(2) of the European Communities Act 1972.

(v)  Application to Gibraltar

  The Directive concerns free movement of services and therefore will apply in Gibraltar.

APPLICATION TO THE EUROPEAN ECONOMIC AREA

  The present directives which are to be re-cast apply to the European Economic Area (EEA) and the Directive is a text relevant to the EEA.

SUBSIDIARITY

  The Government takes the view that the Directive overall complies with the principle of subsidiarity. In particular, the implementation of the single passport for insurers and reinsurers and of a single set of rules for the prudential supervision of insurers and reinsurers throughout the European Union can only be achieved through legislation at the European level.

POLICY IMPLICATIONS

  The Government supports the Solvency II project. The current EU Directives on prudential supervision of insurance are widely perceived to be out of date and in need of fundamental revision. For life and non-life insurance these Directives date back to the 1970s and since then there have been fundamental changes in the insurance sector, financial markets, the approach to accounting for financial institutions, risk management techniques and best practice in the conduct of prudential supervision.

  These changes have been reflected in the prudential requirements for UK insurers and reinsurers that were introduced by the FSA in 2004. These standards are imposed alongside the existing EU Directives and typically are more demanding both in terms of the quantity of regulatory capital insurers and reinsurers are required to hold and in terms of the level of sophistication with which they are expected to assess their risk profile.

  The framework for prudential supervision adopted in Solvency II is broadly consistent with the FSA's approach and this should help to limit the burden on the UK industry from the transition to Solvency II. In addition the implementation of Solvency II will lead to significantly more harmonised prudential standards across the EU, materially reducing the risk that insurers and reinsurers in the UK face a competitive disadvantage through higher domestic regulatory requirements.

  The Government views the Commission's proposed Directive as enabling a step change in the quality of the EU's supervisory framework for insurers and reinsurers and that its core principles are the right ones for the Solvency II project. Five key areas in the Directive are:

—  The Directive requires that insurers value their assets and liabilities on a market consistent basis, including liabilities to policyholders, and that the value of options and guarantees are taken into account.

—  Capital requirements are risk-sensitive and reflect diversification between risks leading to a more efficient use of capital by insurers and reinsurers across the EU.

—  The requirements on firms to assess their own risks and ensure they achieve high standards of internal governance should improve the quality of risk management across the industry as a whole.

—  Subject to supervisory approval firms are allowed to use an internal model to calculate their main capital requirement, which can therefore be tailored more closely to the specific risks of the insurer's business.

—  The Commission's proposal includes an innovative approach to the supervision of insurance and reinsurance groups which is broadly consistent with the position advocated jointly by HM Treasury and the FSA in a discussion paper published in November 2006.[5]

  The Government considers that the broad thrust of the Commission's proposal for the Solvency II framework Directive is appropriate. There are some areas of detail within the Directive where the Government intends to propose amendments. Further, substantial negotiations in Council are anticipated, in particular on two major issues: the supervision of insurance and reinsurance groups and the Minimum Capital Requirement.

  The supervision of insurance and reinsurance groups is a sensitive issue because the Directive will determine the balance of responsibilities between the group supervisor of the parent company and the supervisor of a subsidiary company including where the companies are located in different Member States. The Commission's proposal is for a significant step towards consolidating supervision in the hands of the group supervisor and focussing on capital requirements at the group level. The Government supports this approach but it is likely that this will be a controversial issue for some Member States.

  Solvency II imposes capital requirements at two levels, and the structure and calibration of the lower capital requirement (the Minimum Capital Requirement) has not been precisely determined in the Commission's proposal. The Minimum Capital Requirement is a key element of the framework an insurer whose capital resources fall below this level will be liable to have its authorisation withdrawn. The Commission's proposals in this area are yet to be finalised and are dependent on the results of the third Quantitative Impact Study (an EU wide study to assess the impact of Solvency II).

REGULATORY IMPACT ASSESSMENT

  The European Commission has conducted an Impact Assessment on the Solvency proposal, including a description of the benefits and an analysis of the administrative costs for the EU insurance industry. A key constraint on this analysis is the fact that the directive only outlines the principles and core elements of the Solvency II regime. The actual costs that are imposed on the insurance sector will be influenced strongly by the detail of the Level 2 implementing measures. The Commission plans to conducting Impact Assessments on the key Level 2 implementing measures.

  The central estimate presented by the Commission for the implementation costs of Solvency II for the whole EU insurance sector is £1.3-2.0 billion and £0.2-0.3 billion for on-going costs on an annual basis.[6] The Commission's Impact Assessment does not provide an estimate of what share of these costs would be incurred by insurers and reinsurers in the different Member States. If those shares were proportionate to the relative size of Member States' markets in life and non-life insurance, the UK insurance industry would incur just under one quarter of the overall EU costs.[7]

  It will only be possible to assess the costs for the UK insurance sector more fully once data from the third Quantitative Impact Study is available. This will provide information both on administrative costs for companies and on the costs they incur in holding sufficient capital to meet the regulatory requirements. Publication of a Regulatory Impact Assessment based on this data is scheduled for later this year.

  The UK has already implemented a prudential regime for the insurance sector which is broadly similar to Solvency II. Therefore some of the costs of implementing Solvency II may have already been incurred. However Solvency II will certainly differ from the current arrangements in the UK and it would be incorrect to assume that adapting to the new EU-wide framework will not entail substantial costs for UK insurers.

  The likely benefits of Solvency II for the UK insurance sector are likely to be:

—  A more harmonised approach to prudential supervision of insurers and reinsurers across the EU, reducing the risk that UK companies face a higher regulatory burden than insurers and reinsurers located in other Member States

—  A system of supervision based on one set of principles and rules replacing the current dual application of the existing EU Directives and the FSA's domestic requirements

—  For UK insurance groups operating in other Member States, a streamlined approach to group supervision, reducing administrative costs for groups and allowing them to use their capital more efficiently

  For the EU as a whole additional main benefits are likely to flow from:

—  A more robust insurance sector, providing stronger policyholder protection combined with more efficient use of capital;

—  Improved returns on insurers' asset portfolios flowing from the removal of quantitative restrictions on asset allocation;

—  Stronger risk management and a more realistic valuation of insurance liabilities by firms;

—  Improved international competitiveness of the insurance and reinsurance industry;

—  Improved product design and, in some areas, lower costs for some types of insurance products; and

—  Increased transparency of firms' performance to customers and the markets.

FINANCIAL IMPLICATIONS

  The FSA will incur transitional and on-going administrative costs relating to the implementation and operation of the Solvency II regime in the UK.

  While it is not possible to give a robust estimate of these costs yet, it is reasonable to expect that they will lie in the range of costs incurred by the FSA to implement its own prudential regime for the insurance sector and the costs incurred in its implementation of the Capital Requirements Directive for the banking sector. On this basis the FSA's one-off costs of implementation would be in the range £1.8 million to £12.5 million, with ongoing costs between £400,000 and £1.9 million per annum.[8]

  Direct costs for HM Treasury are likely not to be material.

CONSULTATION

  HM Treasury has consulted extensively on the Solvency II project with the UK insurance industry, in particular the Association of British Insurers (ABI). HM Treasury and the FSA have published two joint discussion papers on Solvency II.[9] A further consultation document is planned for later this year which will include an analysis of the costs and benefits for the UK insurance sector.

TIMETABLE

  The Council negotiations on the Solvency II Directive are due to commence in September under the Portuguese Presidency. The Economic and Monetary Committee of the European Parliament will also begin its deliberations on the Commission's proposal at this time. It is expected that the Council and Parliament should reach political agreement on the Solvency II framework Directive before the end of 2008.

  The Commission's proposal envisages an implementation date for Solvency II of 31 October 2012. This is intended to permit time for the Level 2 implementing measures to be developed and agreed and a period for the industry to adapt to the new framework's requirements.

OTHER OBSERVATIONS (IF APPROPRIATE)

  None

Kitty Ussher MP

Economic Secretary

HM Treasury

7 August 2007

2   Directive 2001/17/EC. Back

3   Directive 2005/68/EC. Back

4   Directive 98/78/EC. Back

5   "Supervising insurance groups under Solvency II", HM Treasury and Financial Services Authority, November 2006. Back

6   The figures presented by the Commission are €2.0-3.0bn and €0.3-0.5bn for transitional and on-going costs respectively; an exchange rate for £/€ of 0.67 is assumed. Back

7   The estimate is based on 2005 data provided in "European Insurance in Figures", Comité Européen des Assurances, June 2006. Back

8   These estimates are based on the information provided in the following Financial Services Authority publications: "Enhanced capital requirements and individual capital assessments for non-life insurers". July 2003; "Enhanced capital requirements and individual capital assessments for life insurers", August 2003 and "Strengthening Capital Standards 2", February 2006. Back

9   "Solvency II: a new framework for prudential regulation of insurance in the EU" and "Supervising insurance groups under Solvency II", HM Treasury and Financial Services Authority, February 2006 and November 2006 respectively. Back