INTRODUCTION

  1.  The purpose of this note is to inform the Committee about progress on the Solvency II Directive. It complements the 7 August 2007 note submitted by HM Treasury which set out the general background to this directive, its coverage and the structure of its main requirements. This note provides an update on key subsequent developments, including completion of the third quantitative impact study (QIS3) undertaken by CEIOPS (the Committee of European Insurance and Occupational Pensions Supervisors: the relevant Lamfalussy Level 3 committee).

BACKGROUND

  2.  Negotiation of European legislation and, ultimately, its implementation in the UK are responsibilities of HM Government. The vehicle for implementing directives affecting financial services is (for the most part) FSA rules. For this reason we are working very closely with HM Treasury in the relevant EU fora. Our work is guided by the objectives set out in the Financial Services and Markets Act 2000 (FSMA): maintaining confidence in the UK financial system; promoting public understanding of the financial system; securing the appropriate degree of consumer protection; and helping to reduce financial crime. FSMA requires us to take into account the international character of financial services and the UK's competitive position. We aim to promote a well-regulated wholesale market which is efficient, orderly and fair and to help retail consumers achieve a fair deal. We focus on identifying and mitigating significant risks, taking account of cost-effectiveness considerations and so not seeking to eliminate all risk of failure within the financial system. We see a progressive shift towards more principles-based regulation, with correspondingly enhanced responsibilities for the senior management of firms, as the preferred way forward for the long term.

  3.  The Solvency II Directive is intended to promote a single market measure, but we expect it to make a significant contribution towards mitigating risk. We have no statutory objective to promote a European single market.

  4.  As outlined in HM Treasury's note, Solvency II will be a Lamfalussy directive. The Commission's Proposal for Level 1 text was published on 19 July 2007 (along with the Commission's Impact Assessment) and discussions in the Council Working Group started in September. We expect, based on the Commission's outline timetable, that "political agreement" on Level 1 could be reached in the second half of 2008 (though naturally, as this is a negotiation, this is subject to some uncertainty). CEIOPS has been asked to deliver its (final, fully consulted) advice on Level 2 implementing measures to the Commission by October 2009. Negotiations on Level 2 may then be completed by late 2010. The Commission's intended implementation date is October 2012.

  5.  For Solvency II, we support an appropriate adaptation to insurers of the three-pillar structure of the 2004 Basel Framework for banks: pillar 1—market-consistent valuation standards for assets and liabilities, and risk-responsive capital requirements to help address the risk of financial deterioration in adverse circumstances; pillar 2—supervisory review, including increased focus on the quality of risk and capital management in particular insurers; pillar 3—regulatory reporting and public disclosure. In many respects this would reflect the approach that we have taken in our domestic insurance reforms (introduced in 2004), including encouraging the development of liability and capital modelling capability by insurance firms (Individual Capital Adequacy Standards: ICAS). Accordingly, the Directive should serve to underpin the modernised, risk-based and proportionate regime that we now have in place in the UK. We believe it will promote greater convergence of regulatory requirements and practices across the EU, and bring greater cross-sector convergence. The Directive provides a good opportunity to enhance the supervisory model for insurance groups with subsidiaries in different Member States. In order to help secure a proportionate directive we have provided support to the Commission to produce a robust Impact Assessment to accompany the Directive proposal. We intend to assist actively with a further Impact Assessment to accompany the Level 2 proposals.

  6.  Under Pillar 1, firms will be required to hold capital to at least the level of the Solvency Capital Requirement (SCR)—to mitigate the risks arising if the value of a firm's assets falls, or its liabilities increase, under adverse conditions. The SCR is to be calibrated at a 99.5% level of confidence that the firm's assets remain sufficient to meet its liabilities, over a one year time-horizon. (This is consistent with the corresponding calibration of our ICAS regime). A firm could calculate the SCR by "standard formula", or, subject to supervisory approval, use its own capital model (the "internal model" approach). Solvency 2 also sets a Minimum Capital Requirement (MCR), below which level policyholders are considered to be at unacceptable risk. A firm whose capital falls below the level of the MCR, and which cannot restore capital in short order, would be closed to new business. The MCR is intended to offer a regulatory intervention point, so that, to the extent possible, a firm's book may be de-risked and existing business run-off on a solvent basis, or transferred to another firm.

  7.  CEIOPS conducted is latest Quantitative Impact Study ("QIS 3") between April and July 2007. Its report on the EEA-wide results of this exercise was publised on 20 November. Simultaneously, a report on the UK results was published on the FSA website. QIS 3 tested the suitability and financial impact on firms of key aspects of the Commission's Level 1 text, along with CEIOPS' work-in-progress on the related Level 2 implementing measures. Key aspects tested were the proposed requirements on: the valuation of technical provisions for liabilities to policyholders; the implications for firms' capital ("own funds"); the Minimum Capital Requirement (MCR) and the Solvency Capital Requirement (SCR). In addition to quantitative returns, firms were invited to complete a qualitative questionnaire, including comments on practicability and resourcing implications. In the UK, 39 life firms and 46 non-life firms (including Lloyd's of London) participated, comprising 65% and 75% of the respective markets by premium income. We believe sufficient small firms participated to enable useful conclusions to be drawn about potential impacts on them. 11 groups submitted group responses.

ENGAGING UK STAKEHOLDERS

  8.  We continue to devote much effort to active engagement of UK stakeholders. Together with HM Treasury we published two discussion papers in 2006: Solvency 2-a New Framework, and Supervising Insurance Groups under Solvency 2. A further discussion paper on supervision of insurance groups is being prepared. To secure engagement on Solvency 2 at senior levels with the insurance industry, there are quarterly meetings of a "High Level Group" chaired by HMT on which the Managing Director of the FSA's Wholesale Business Unit represents the FSA. Industry members include the DG of the ABI, a representative of the Board for Actuarial Standards, and the CEOs of a number of major insurance companies. The FSA chairs an Insurance Standing Group, which acts as a pre-consultation forum and more generally keeps the industry up to date on a monthly basis with the progress of European discussions. Papers and minutes of these meetings are published on the FSA website. To support the UK execution of QISs, we have devoted resources to a number of workshops for firms (often in liaison with the relevant trade associations), operated a technical query service for participants, and organised feedback sessions on the results. We have a full speaking programme at relevent conferences.

FSA'S ROLE IN CEIOPS (AND WIDER RESOURCING)

  9.  The next 12 months and beyond will see intensive activity in the Council Working Group (CWG) and, increasingly, in the European Parliament as Level 1 negotiations progress; also in CEIOPS as it draws up advice on Level 2 implementing measures and conducts QIS 4. (CEIOPS' advice to the Commission on the specification for QIS 4 is due by 20 December). We will continue to be active in CEIOPS and have stepped-up the level of our support to HM Treasury in the CWG. The FSA has one staff member on secondment to support the CEIOPS' Secretariat, two others on secondment to the Insurance Unit of the Commission, and one on secondment to the Secretariat of the European Parliament's Committee on Economic and Monetary Affairs.

  10.  Hector Sants as CEO of the FSA has succeeded John Tiner as our Member of CEIOPS and has also been elected to its Managing Board. CEIOPS' work on Solvency II is progressed through a variety of expert groups—we chair the important Internal Models Expert Group and are active participants in all other relevant working groups. We are proactive in offering technical briefings to MEPs.

PROGRESS ON SOLVENCY II AND KEY OUTSTANDING ISSUES

  11.  The Commission's draft Level 1 text meets most of the UK objectives, crucially by requiring market-based valuations of assets and liabilities and through application of the "three-pillar" approach, similar to Basel 2. It also gives a fair reflection of the UK proposal on group supervision. However, results from QIS 3 for the UK, and the EEA more broadly, suggest that some significant work is required (at Levels 1 and 2) on the structure and calibration of capital requirements. In particular, the form and calibration of the Minimum Capital Requirement (MCR) is a significant unresolved issue. In addition , alongside HMT, we stand ready to defend key modernising features of the proposed framework as necessary during Council Working Group discussions. We have reservations about the possibility that the Level 2 provisions could in some areas emerge as over-prescriptive and "maximum harmonising". Superficially attractive from the (anti-) gold-plating perspecive, such an approach could be dangerous in practice, fettering supervisors' ability to deal with specific situations in an intelligent, risk-based and timely way.

IMPACT OF SOLVENCY II AND QIS 3 RESULTS

  12.  The Commission's impact assessment of the Level 1 text was published with the Level 1 Proposal in July. We consider it was a marked improvement on previous Commission impact work and was fit-for-purpose. It is very clear, however, that the overall impact of Solvency II will depend heavily on the outcome of the Level 2 negotiations, and so there will be material uncertainties until those are concluded (prospectively in late 2010). The Commission has committed to a full impact assessment of Level 2 and is pressing CEIOPS to do the same in drawing-up its advice. As well as capital costs, this should include an explicit consideration of administrative expenses imposed on firms, for example through reporting and disclosure requirements.

  13.  Our current "best-estimate" of the impact of Solvency II is based on CEIOPS' QIS 3 study. The UK results showed that CEIOPS' work on developing appropriate Level 2 standards has progressed since QIS 2. But further work is needed. In particular, QIS 3[10] showed that:

(a)  CEIOPS' preferred option of a "modular" MCR does not work for life firms, giving a wide variance in ratios of the MCR to SCR across firms. This would cause difficulties to the operation of the "regulatory ladder of intervention" in firms and to firms' capital planning;

(b)  further progress is needed in refining the "standard" SCR calculation, including to provide a realistic calibration of the non-life underwriting risk component and to remodel the policy lapse/surrender risk requirement for life linked business;

(c)  greater clarity was needed in the "own funds" criteria for classifying different types of capital; and

(d)  the calibration of the equity risk stress in the SCR is a major factor in determining the total capital required by life insurers.

QIS 4

  14.  In CEIOPS, work continues on drawing up a revised specification for the QIS 4, which is due to run from April to July next year. There remains a wide range of views on the structure of the MCR, and on calibration of the equity risk stress in the SCR. While, technically, these are Level 2 details, feedback from the industry and other stakeholders during the QIS 4 consultation period (planned to run through January and into February 2008) will need to be wieghed carefully before the specifications are finalised.

PROPORTIONALITY AND SMALL FIRMS

  15.  There are a number of different ways in which the principle of proportionality will be built into Solvency II for all firms, along with some specific small firms' adaptations. Level 1 text requires that: "requirements of the directive are applied in a manner which is proportionate to the nature, scale and complexity of a firm's business"—a principle which spans all three pillars of the framework. Application of this principle will need to be elaborated at Level 2, and CEIOPS has been asked to develop a first tranche of advice on this topic by May 2008. Very small insurers (the Proposal text suggests those with annual premiums below EUR 5 million) will be excluded from the scope of application of the directive (being subject instead to national regulation).

  16.  In determining their required capital (the SCR), firms will be able to choose between using an internal model (subject to supervisor approval that it meets the necessary standars) or the "standard formula". Indeed, firms may choose to model their more material risks, but apply the more simple standard approach to lesser risks, or lines of business—a feature that may be particularly helpful to niche non-life firms. Within the standard approach, too, there are some options: smaller firms with simple risk profiles will have access to some simplifications. QIS 4 should see the first systematic testing of the simplifications available for small firms.

PREPARING FOR IMPLEMENTATION AND INTERNAL MODEL APPROVAL

  17.  Naturally, as the project advances, and in particular once Level 2 standards are more developed, the FSA will increase activity aimed at helping to ensure that UK firms are well-prepared for implementation of Solvency II. We have begun discussions with the ABI, on planning the process for FSA review and approval of firms' internal models (where they wish to use them). This will build on and carry forward our routine ICAS (current domestic standards) review work. In dialogue with the industry, and drawing on our experience with implementation of the Capital Requirements Directive, we aim to develop arrangements that:

(a)  ensure that Level 2 standards for internal models are developed in a manner which builds upon, and does not conflict with, industry best practice;

(b)  ensure that UK firms are well-placed to understand the likely practical interpretation of Level 2 standards as they emerge, and application processes and deadlines, so that they can prepare and achieve approval to use their internal models from "day 2"; and

(c)  ensure that FSA has a good understanding of the number of firms that are likely to seek internal model approval, aiding our planning and resourcing.

November 2007