Capital Consequences: Part One

In the first part of a two part article, Steven McEwan examines the current solvency and capital requirements that apply to non-life insurers and what happens when they are not being satisfied. The second part will examine the differences that are expected under Solvency II.

Since the implementation of the first Non-Life Insurance Directive of 1973, non-life insurers in the EU have been required to maintain a "solvency margin". The solvency margin is a buffer of assets in excess of foreseeable liabilities which are available to absorb unforeseen losses. An insurer's solvency margin must at all times exceed its "required solvency margin", which is calculated on the basis of its premiums, claims and reinsurance ratios.

The purpose of these rules is to minimise the likelihood of the insurer becoming insolvent and therefore being unable to pay its policyholders and any insurers to whom it provides reinsurance protection.

In the UK, Financial Services Authority rules represent the solvency margin by the concept of "capital resources", and they represent the required solvency margin by the concept of the "capital resources requirement". This terminology has been used since the end of 2004, when the FSA aligned the terminology used in the regulation of insurers with that used in the regulation of banks and investment firms.

At the same time that it adjusted the terminology, the FSA classified the capital resources requirement as the "Pillar 1" capital requirement and, in an effort to introduce a greater amount of risk-sensitivity, it created the "Pillar 2" capital requirement, which was not required by the EU directives. The insurer must now hold capital resources equal to the higher of the Pillar 1 and Pillar 2 capital requirements.

The Pillar 2 capital requirement is familiar to insurers as its individual capital assessment combined with individual capital guidance given by the FSA.

As a measure of the buffers required to be maintained by the insurer, it is more sensitive to the individual risks faced by the insurer than the Pillar 1 capital requirement.

The object of the Pillar 2 capital requirement is to determine the amount of capital resources that are required to be held by the insurer so that it will have a probability of remaining solvent over one year of not less than 99.5%. Determining this requirement involves extensive actuarial calculations and a number of fine judgements. This often leads to disagreement between the insurer and the FSA.

What happens if the requirements are not met ?

The FSA rules require notifications, reports and plans to be provided by insurers who are not satisfying the applicable capital requirements. In addition, a number of powers are available to the FSA for use against such insurers to encourage them to try to raise additional capital (for example, by issuing additional shares or subordinated debt) or to restructure their business so as to reduce the capital requirements (for example, by derisking their investment portfolios, entering into additional reinsurance arrangements, transferring business to another insurer or, in some cases, entering into a solvent scheme of arrangement).

The decision of which power to exercise normally depends on the relevant circumstances which, in increasing order of seriousness, are: (a) a breach of the Pillar 2 capital requirement as set out in the ICG, (b) a breach of the Pillar 2 capital requirement as set out in the ICA; and (c) a breach of the Pillar 1 capital requirement.

It is important to note that the insurer's financial position does not have to have fallen to the level of "insolvency" in the sense meant under ordinary company law. The relevant breach is a failure to maintain a financial position which is sufficiently above the insolvency level to be satisfactory in accordance with the special requirements that apply to insurers for the protection of policyholders and any insurers to whom they provide reinsurance protection.

The most effective power available to the FSA is the threat of exercising the other powers. If an insurer's capital resources fall below the ICG but not the ICA, the FSA will enter into a dialogue with the insurer giving a clear indication that if the matter is not addressed to its satisfaction then it will take formal action. This is usually sufficient to spur the insurer into rapid action and often the matter is resolved consensually.

If a resolution is not reached, the FSA may decide to require the production of a "skilled person's report". This will generally involve the appointment of an actuary who is independent from the insurer who will examine the issues in dispute and express his view on them. The report may support the insurer's view set out in the ICA or it may provide additional evidence on the basis of which either the insurer will accept the ICG or the FSA will feel confident in taking stronger action.

The FSA has power to vary the insurer's regulatory permission so as to require it to take or not take certain action (an "own initiative variation of permission" or "OIVOP"). Among other matters, it may require the insurer not to make or repay loans to fellow group companies, not to pay dividends and not to return capital to its parent company. It may also impose restrictions on the types of assets in which the insurer may invest.

In very serious cases, the FSA can use its OIVOP power to restrict or cancel the permission of the insurer to write new business. This will usually be extremely damaging to the insurer's business since, unlike the powers mentioned above, it is generally impossible to avoid it becoming public knowledge, even if the insurer thinks it can recover quickly and persuade the FSA to reinstate the permission in full.

The ultimate remedy of the FSA is to petition for the winding up of the insurer. This would result in the crystallisation of claims, so would be a very unsatisfactory outcome and it would almost certainly destroy any remaining shareholder value. The FSA would be likely to adopt this remedy only in the most serious of cases where no other progress can be made in discussions with the insurer.

The Lloyd's insurance market
Lloyd's has primary responsibility for solvency and capital requirements in the Lloyd's insurance market, subject to overall supervision by the FSA. Business in the Lloyd's market is written on behalf of successive years of account of each syndicate, and this means that Lloyd's control of solvency and capital operates more automatically than the control exercised by the FSA.

Each year, the managing agent of each syndicate is required to prepare an ICA for the syndicate. The ICA is reviewed by Lloyd's, and Lloyd's uses it to determine the amount of "funds at Lloyd's" which each member of the syndicate is required to deposit as a condition of business being written on his behalf for the following year of account. The FAL constitutes a buffer of assets which are available if the syndicate's assets are insufficient to meet claims on the policies written by it.

A member which does not provide the required amount of FAL is subject to an automatic reduction in the amount of business that may be written on his behalf. If members cannot provide sufficient funds at Lloyd's then there will be a corresponding reduction in the premium limits to which the syndicate is subject. The point may be reached where the syndicate cannot write enough new business to be viable, in which case it is likely to go into run-off.

Steven McEwan is of counsel at Hogan Lovells International LLP. He specialises in corporate and regulatory insurance.

FOR THE SECOND PART OF THIS ARTICLE SEE THIS WEEK'S POST OUT ON IN PRINT AND ONLINE ON THURSDAY