05 December 2012

Risk.net: New own funds specifications add capital restrictions

New technical specifications on Solvency II's capital requirements make some significant changes to the way insurers calculate their own funds, but they also leave some unanswered questions.

Many of the changes bring the specifications in line with the draft level 2 implementing measures that were produced by the European Commission in October 2011. However, in relation to the calculation of an insurer’s own funds, the specifications have gone beyond the draft level 2 text.

The new specifications raise a number of key issues for insurers in relation to own funds. First and foremost, they provide a stricter classification of eligible capital instruments than many predicted. The organisation of own funds capital into tiers has been tightened up and existing restrictions on top-quality instruments enhanced and formalised.

Second, the specifications raise questions about the benefits insurers will receive from expected profits included in future premiums (EPIFP) because of the definition of contract boundaries, a rule that limits the amount of expected future profits that can be counted as regulatory capital. EIOPA’s report on the fifth quantitative impact study (QIS5) noted that “the different interpretations of the contract boundaries definition have led to inconsistency between undertakings and may also have led to incorrect calculation of technical provisions”. The updated specifications do more to muddy the waters, not less.

Finally, the extent of transitional measures for instruments that fall outside the own-funds tiering structure has not been clarified. While some grandfathering arrangements are expected to be incorporated in the final level 2 text for hybrid and subordinated debt, insurers are still concerned that the transitional arrangements will be too restrictive. 

EIOPA insists that the updated specifications do not represent the final requirements that will feature in the completed level 2 text, stressing that this specification, the first of two parts, is intended to be used for future quantitative assessments. However, insurance industry experts say they do provide a good indication of the authority’s current thinking on the rules and are a much-needed refreshment of the specifications since QIS5.

When the second part of the updated specifications is released insurers may get a better sense of how unclassified instruments will be grandfathered into Solvency II.

Predicting the future of Solvency II is a near-impossible exercise. While there is still so much to be decided upon in the political sphere, the latest technical specifications represent a firming up of existing rules first unveiled in the draft level 2 text and reiterated during QIS 5.

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