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Solvency II: Draft Level 2 measures finally published

16 October 2014
On Friday, 10 October 2014 the European Commission published its draft of a delegated act that contains the key rules to be made under Solvency II.  The draft is subject to approval by the European Parliament and the Council.

The rules are referred to as a "delegated act" because they will be made by the Commission under powers delegated to the Commission by the Solvency II Directive.  The Solvency II Directive was originally made in 2009 and was amended earlier in 2014 by another Directive referred to as Omnibus II.

More commonly, the rules are referred to as the "Level 2 measures" because they form the second level of legislation through which Solvency II will be implemented.  Level 1 is the Directive itself (as amended), Level 2.5 will comprise technical standards to be proposed by the European Insurance and Occupational Pensions Authority (EIOPA) and approved by the Commission, and Level 3 will constitute guidance to be issued by EIOPA with which insurers and reinsurers will be expected (though not legally obliged) to comply, with a requirement to explain to regulators where they do not comply.

The rules can be read on the EU website here.

The publication marks the end of a long period of private consultation by the Commission, based on numerous earlier drafts that were made available to insurers and reinsurers in the EU.  It sets out extensive detail that was not contained in Solvency II itself.  In many cases this was because it was felt that the Directive would be clearer if it did not contain too much detail, while in other cases it was because, in 2009, a consensus had not yet been reached on important issues that would significantly affect the insurers and reinsurers who will be required to comply with Solvency II.

The most significant feature of the Level 2 measures is that they will take the form of an EU Regulation.  This means that they will be directly binding on insurers and reinsurers in the EU, without the need for legislation made by member states.  This contrasts with all previous EU insurance rules which have taken the form of a Directive which member states have been required to incorporate into their own national legislation and regulatory rules.

Using a directly effective Regulation is a more efficient means of legislating in the EU.  It removes the need for further layers of rules to be made by regulators in each member state.  It should also remove the risk that differences arise between member states because of different national rules (this risk can of course be addressed by the "intelligent copy-out" approach that UK regulators have adopted).  On the other hand, cutting out the national regulator may affect the level of engagement that the national regulators have with the rules and their ability to use this engagement to regulate effectively, particularly in respect of the many important areas that remain their responsibility under Solvency II, such as the approval of internal models.

Another important consequence of publishing the Level 2 measures in the form of a Regulation is that, under powers conferred in it in 2010, EIOPA will be able to enforce the provisions of the Regulation directly against insurers and reinsurers where it is determined that the applicable national regulator has failed to do so.  Because previous EU insurance rules have been made under Directives, EIOPA has not previously been able to exercise these powers.  As a result, insurers and reinsurers who breach the Level 2 measures will face the prospect of regulatory action either from their national regulators or, if their national regulators fail to act, from EIOPA.

The Level 2 rules are divided into a number of titles and chapters.  Three areas which are likely to attract significant scrutiny are:

  • Title I, chapter III: Rules relating to technical provisions: These rules will determine the valuation of insurance and reinsurance obligations.  Important issues contained in these rules are the matching adjustment (which will allow a greater discount to be applied to long-term liabilities in certain circumstances) and contract boundaries (which will determine the extent to which future obligations and also future profits can be recognised), both of which have been high profile issues over recent years.
  • Title I, chapter V: SCR standard formula: These rules set out the approach for the calculation of the SCR by the majority of insurers and reinsurers who will use the standard formula (rather than an internal model).  A key component of the formula is the Market Risk Module, which sets out the capital charges for holding different types of assets.  This Module has attracted a great deal of attention over recent years due to the tension between the need to discourage risky investments on the one hand, and the need to encourage socially valuable investments on the other hand such as infrastructure investments.  The capital charges are thought to have been gradually reduced since 2009.  If there is to be an objection from the European Parliament, it is in relation to this Module that the objection is most likely.  This Module will be of great interest even for insurers and reinsurers who hope to use an internal model, since their proposed model will be compared with the standard formula as part of the regulatory approval process.
  • Title I, chapters XII and XIII: Public disclosure and reporting:  These rules set out the requirements for the various reports that insurers and reinsurers will be required to produce, including the solvency and financial condition report, the own risk and solvency report and their quarterly and annual reports to regulators.  A structure for the solvency and financial condition report has been provided in an annex to the draft Level 2 measures, although this is still quite high level.  Regulatory reporting will, among other things, depend on the production of quarterly and annual templates, which have not yet been published.  Insurers and reinsurers will be very keen to receive much more detail on what they will be required to produce for reporting purposes so that they can prepare their internal systems accordingly.  Reporting was an area of considerable strain for banks when the EU Capital Requirements Regulation entered into force earlier this year, with the reporting templates not finalised until several weeks after the Regulation became effective, and insurers and reinsurers will not wish to be put in the same position.

The publication of the draft Level 2 measures does not mark the end of the Solvency II rule-making process.  There remains the possibility of further negotiation if the European Parliament or the Council objects to the Commission's draft.  The current draft will become law unless the Parliament or the Council raises an objection within three months, although they have the right to extend the period for up to an additional three months.

Even assuming the draft Level 2 measures become law, much more is still needed – most notably the reporting templates.  Extensive further guidance, building on the Level 2 measures, will soon be published by EIOPA, representing the Level 2.5 and Level 3 measures.  In addition, national regulators are in the process of making the national rules in the areas not covered by the Level 2 measures, which the Level 1 Directive requires them to implement.

However, notwithstanding the volume of regulation that is still awaited, the fact that the draft Level 2 measures have finally been made public should mean that insurers and reinsurers can plan with more certainty for the changes due to be implemented when Solvency II becomes effective at the beginning of 2016.

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