09 April 2014

Risk.net: Own funds rule will reduce reported solvency ratios, say insurers

Insurers are challenging the European Commission about an amendment to rules that restrict the use of capital under Solvency II, amid fears that the changes will cause solvency ratios to worsen, making firms appear financially weaker to shareholders and creditors.

The change in the wording of the delegated acts (the second stage of the Solvency II legislative process) is intended to prevent levels of insurers' eligible capital from falling in stressed conditions. Eligible capital is the share of an insurer's total capital (own funds) eligible to cover the solvency capital requirement (SCR) under the directive.

But industry representatives say the new methodology is ill-conceived, arguing that insurers will be stopped from including in eligible capital a potentially large share of their lower-quality capital instruments, such as subordinated debt or some hybrid capital. As a result, firms' reported solvency ratios (how much eligible capital they have compared with their capital requirements) could decrease significantly.

This negative side-effect of the changes was flagged in discussions between the commission and insurance representatives, but no change was made in the latest draft proposals, dated 14 March.

Under Solvency II, capital is divided into three tiers, depending on the quality of financial instruments and their capacity to absorb losses. The directive stipulates the proportion of high-quality instruments that insurers must use to cover the SCR. Tier I capital can include paid-in ordinary share capital, initial funds and future profits. Tier II and Tier III instruments, which include subordinated debt and other less robust instruments, can be used to cover the rest of the regulatory capital requirement, as long as Tier III accounts for no more than 15 per cent.

The figures remain unchanged in the draft proposals that the commission circulated in March. However, a controversial amendment in the wording affects the way the proportions are determined. In a 2011 version of the delegated acts, the minimum level of Tier I capital and the maximum level of Tier III capital were expressed as a percentage of eligible own funds. The most recent draft proposes that insurers calculate the limits as a percentage of the SCR.

The commission says the amendment will avoid a pro-cyclical effect under the previous rules in circumstances where the value of Tier I capital falls. In this scenario, the lower value of a firm's Tier I capital would cause the level of its total eligible capital also to fall. Linking the proportions to the value of the SCR will make firms' solvency ratios more stable, as the value of Tier II and Tier III capital that is eligible becomes independent of Tier I.

But the proposed change will have the unintended result of making their SCR ratios worse by reducing in most cases the amount of eligible Tier II and III capital. This will be more apparent when available capital instruments are of high quality and exceed the SCR by a long way.

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