In April, the European Commission published for consultation its draft technical specifications for its fifth Quantitative Impact Study on Solvency II (“QIS5”). Further changes are expected to be made during and after the consultation process before the final version of the technical specifications is published and the QIS5 exercise launched. The exercise itself will run from August to November 2010, with the report publishing the results expected in April 2011.
A principal issue which will affect many of our European clients is the introduction of grandfathering provisions into Tier 1 or Tier 2 capital items.
The Commission accepts that grandfathering transitional provisions are necessary to ensure a smooth transition to Solvency II. The grandfathering provisions contained in QIS5 have been aimed at making grandfathering practicable.
The introduction of grandfathering in principle is a welcome move from the Commission. A number of our clients have recently been looking at the requirements for instruments to qualify as capital under the Solvency II regime.
However, QIS5 does not currently state if these transitional provisions will apply to pre-Solvency II instruments on a permanent basis, or merely for a temporary period. In addition, these are current proposals only and are not indicative of the final transitional provisions.
A summary of the grandfathering provisions is set out below. Note this is a summary only and we would advise that you check with your usual Linklaters team whether any components of your capital instruments comply with the current grandfathering proposals.
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Tier 1
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Tier 2
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Most deeply subordinated or senior only to the most deeply subordinated in a winding up |
Rank after policyholder and beneficiaries claims and non-subordinated creditors |
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Not cause or accelerate insolvency |
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Fully paid and immediately available to absorb losses |
Fully paid and immediately available to absorb losses |
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The term is not less than ten years |
The term is not less than five years |
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Repayable/redeemable at the option of the insurer subject to the approval of the supervisory authority |
Repayable/redeemable at the option of the insurer subject to review from the supervisory authority |
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Incentives are moderate, step ups must not apply for ten years and not exceed 100 bps or 50% of the initial credit spread |
Incentives are moderate, step ups must not apply for five years and not exceed 100 bps or 50% of the initial credit spread |
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Must be able to cancel or defer coupon/dividends in times of stress |
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Free from encumbrances |
Free from encumbrances |
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Possess some features which enable it to absorb losses on a going concern basis |
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We would broadly expect innovative Tier 1 and Tier 2 instruments complying with the relevant current UK GENPRU rules to meet the draft QIS5 requirements for grandfathering. However, the position regarding Tier 2 instruments is obscured by certain disparities between the GENPRU rules and the draft QIS 5 requirements, as outlined below:
“The item is undated or has an original maturity of at least 5 years. The maturity date is deemed to be the first opportunity to repay or redeem the basic own-funds item unless there is a contractual obligation to replace the item with an item of the same or higher quality capital.”
- GENPRU 2.2.173R provides that Tier 2 instruments may be redeemed at the option of the Issuer prior to the fifth anniversary of the issue date upon the occurrence of a change in law or regulation (in accordance with GENPRU 2.2.71R to GENPRU 2.2.73G). There is no requirement to issue replacement instruments.
- QIS 5 provides no guidance on the acceptability or otherwise of such early calls. One might anticipate however that such calls may, when the final rules are settled, be accepted if Solvency II were to follow the approach of the proposed CRD terms dealing with hybrid capital instruments issued by banks (Article 63(a)(2) of which expressly contemplates early calls for tax and regulatory triggers) and the FSA’s proposed rules for implementing the CRD as set out in CP09/29.
“The item is only repayable or redeemable at the option of the insurance or reinsurance undertaking, subject to review from the supervisory authority.”
- GENPRU 2.2.159R(5) provides that Tier 2 instruments may become due and payable prior to the fifth anniversary of the issue date upon the occurrence of an event of default complying with GENPRU 2.2.159R(2) (limited to non-payment of any amount falling due under the terms of the capital instrument or the winding-up of the issuer).
- QIS 5 does not address the question of redemption upon an event of default. However, it would not seem tenable for the rules to prohibit a holder enforcing his claims where the issuer is either unable to discharge its payment obligations or is in the process of being wound up.
In other jurisdictions, such as Germany, there have so far not been any rules or regulations stipulating the requirements for the various tiers of own funds of an insurer. So issues of:
- subordinated debt under Article 27(3)(a) of the Consolidated Life Directive or Article 16(3)(a) of the First Non-Life Directive (as amended) (“subordinated debt”); and
- undated subordinated debt with no specified maturity date (“perpetual securities”) under Articles 27(3)(b) and 16(3)(b) of the same Directives
have been made under more widely varying terms in those jurisdictions. Subject to any additional terms, it is likely that debt complying with the requirements for either of these categories under the Directives will meet the draft QIS5 requirements for grandfathering as Tier 2 own funds under Solvency II. The draft Tier 1 requirements are less obviously going to be satisfied. With the right level of subordination and no ability to cause or accelerate insolvency, perpetual securities may well be grandfathered as Tier 1 own funds. Subordinated debt would, in addition, need to have an original maturity of at least 10 years (unless there is a contractual obligation to replace the item with an item of the same or higher quality capital), no incentives to redeem before 10 years, the ability to defer coupons and to have some loss absorbency features in order to be grandfathered as Tier 1.
All German deals make the exercise by the issuer of its call right subject to prior replacement by other own funds of at least equal or better quality or, alternatively, prior approval by the regulator. The draft requirements for grandfathering as Tier 1 require a contractual obligation to replace the capital so it should be open to issuers to forego the right to seek regulatory approval for a deal which has a call prior to 10 years, thereby allowing that deal to qualify for Tier 1 (if all the other Tier 1 requirements are met). We would hope though that the criteria can be clarified before the transitional provisions are finalised.
It will, in any event, be necessary to monitor the transitional provisions as they develop and are finalised – and to consider carefully the individual terms of each instrument or agreement to confirm whether it will be grandfathered.
For further information, please contact:
Victoria Sander (victoria.sander@linklaters.com, (+44) 20 7456 3395);
Peter Waltz (peter.waltz@linklaters.com, (+49) 69 7100 3457).
