1. INTRODUCTION AND PURPOSE

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1 Solvency Assessment and Management: Pillar I - Sub Committee Capital Resources and Capital Requirements Task Groups Discussion Document 53 (v 10) Treatment of participations in the solo entity submission under SAM EXECUTIVE SUMMARY This document discusses the considerations regarding the treatment of participations in the solo entity submission under SAM. It makes the following recommendations: The criteria used to determine whether an investment is a participation should be as specified under Solvency II (by virtue of share ownership or by virtue of the exertion of dominant or significant influence). Details of these are provided. No distinction should be made between strategic and other participations, unlike under Solvency II. The definition of a financial and credit institution (F&CI) should be similar to that specified under Solvency II. Details of this are provided. Participations should be valued at fair value, in line with SAM position paper 39. Non-financial participations should be considered under and stressed by the appropriate equity stress (SA, global, or other equity). Non-South African (re)insurance participations should be treated in the same way as South African equivalents. Consensus could not be reached on the following points and hence no final recommendation is made. In each instance two possible approaches are specified. The treatment of F&CI participations in own funds and the SCR: View 1 is to align the treatment of these closely with the equivalent under Basel III; View 2 is to treat these exactly as specified in EIOPA-DOC-12/467. The treatment of South African (re)insurance participations in own funds and the SCR: View 1 is to consider these under a separate participations risk module (possibly modules) with a stress determined as a function of the participation s SCR-coverage. View 2 is to treat these exactly as specified in EIOPA-DOC-12/467 (i.e. as standard equity investments). The treatment of participations in the concentration risk module: View 1 is to include participations in the concentration risk module unless the specifics of the risk profile are reflected elsewhere (e.g. under the treatment of F&CI participations or view 1 for (re)insurance participations). View 2 is to treat participations in the concentration risk module exactly as specified in EIOPA-DOC- 12/467 (i.e. exclude participations from the concentration risk module provided certain criteria are met). Both views allow for the risk associated with F&CI participations through deductions from own funds and allow for the risk associated with other participations through the calculation of the capital requirement.

2 1. INTRODUCTION AND PURPOSE The (re)insurance industry invests in a variety of assets, including participations. These are companies in which the (re)insurer owns a significant proportion of the issued share capital or over which it exerts significant influence / control. The purpose of this document is to set out the treatment of participations for the solo entity submission of (re)insurers under SAM. This includes their treatment in the balance sheet, own funds and the solvency capital requirement calculations. To this end, various IAIS documents, the Solvency II principles and the guidance available in other jurisdictions (specifically Canada and Australia) are considered. The appropriateness of the various approaches is assessed in the South African context. Three categories of participation are considered: financial and credit institutions, (re)insurance companies, and other (non-financial) participations. Furthermore, the concept of strategic participations is discussed. Where consensus on treatment was reached a final recommendation is presented. Where consensus could not be reached separate recommendations in line with each viewpoint are presented. The document also recommends a technical definition of participations for use in SAM. 2. INTERNATIONAL STANDARDS: IAIS ICPs International Association of Insurance Supervisors (IAIS) Insurance Core Principle (ICP) 17 Capital Adequacy, adopted 1 October 2011 is considered in this section. The portions of this ICP that are relevant to the topic covered in this discussion document consist of Section ( Identification of capital resources potentially available for solvency purposes ) and Section ( Criteria for the assessment of the quality and suitability of capital resources and Determination of capital resources to meet regulatory capital requirements ). 2.1 Paragraphs to : Treatment of assets which may not be fully realisable on a going-concern or wind-up basis Supervisors should consider that, for certain assets in the balance sheet, the realisable value under a wind-up scenario may become significantly lower than the economic value which is attributable under going-concern conditions. Similarly, even under normal business conditions, some assets may not be realisable at full economic value, or at any value, at the time they are needed. This may render such assets unsuitable for inclusion at their full economic value for the purpose of meeting required capital. Page 2 of 77

3 Examples of such assets include: intangible assets: their realisable value may be uncertain even during normal business conditions and may have no significant marketable value in run-off or winding-up; Goodwill is a common example; future income tax credits: such credits may only be realisable if there are future taxable profits, which is improbable in the event of insolvency or winding-up; investments in other insurers or financial institutions: such investments may have uncertain realisable value because of contagion risk between entities; also there is the risk of double gearing where such investments lead to a recognition of the same amount of available capital resources in several financial entities; and company-related assets: certain assets carried in the accounting statements of the insurer could lose some of their value in the event of run-off or winding-up, for example physical assets used by the insurer in conducting its business which may reduce in value if there is a need for the forced sale of such assets. Also, certain assets may not be fully accessible to the insurer e.g. surplus in a corporate pension arrangement The treatment of such assets for capital adequacy purposes may need to reflect an adjustment to its economic value. Generally, such an adjustment may be effected either: directly, by not admitting a portion of the economic value of the asset for solvency purposes (deduction approach); or indirectly, through an addition to regulatory capital requirements (capital charge approach). 2.2 Paragraph In paragraph it is stated that when a supervisor considers the approach to adopt to treat assets that might not be fully realisable on a going-concern or wind-up basis, it should: choose the approach which is best suited to the organisation and sophistication of the insurance sector and the nature of the asset class and asset exposure considered. It may also combine different approaches for different classes of assets. Whatever approach is chosen, it should be transparent and consistently applied. It is also important that any material double counting or omission of risks under the calculations for determining the amounts of required and available regulatory capital is avoided. 2.3 Paragraph Paragraph lists factors that may be considered by the supervisor in identifying what may be regarded as capital resources for solvency purposes. The factors includes systemic risks which could affect the amount and/or quality of capital resources and the relationship between risks faced by insurers and those faced by other financial services entities, including banks. Page 3 of 77

4 2.4 Paragraph The availability of capital instruments may also be impaired when capital is not fully fungible within an insurer to cover losses arising from the insurer s business. Whereas the fungibility of capital and transferability of assets is primarily an issue in the context of group solvency assessment, it may also be relevant for the supervision of an insurer as a legal entity. 2.5 Paragraphs to Paragraphs to cover additional guidance for insurance groups and insurance legal entities that are members of groups. Multiple gearing and intra-group creation of capital Double gearing may occur if an insurer invests in a capital instrument that counts as regulatory capital of its subsidiary, its parent or another group entity. Multiple gearing may occur if a series of such transactions exist Intra-group creation of capital may arise from reciprocal financing between members of a group. Reciprocal financing may occur if an insurance legal entity holds shares in or makes loans to another legal entity (either an insurance legal entity or otherwise) which, directly or indirectly, holds a capital instrument that counts as regulatory capital of the first insurance legal entity For group-wide capital adequacy assessment with a group level focus, a consolidated accounts method would normally eliminate intra-group transactions and consequently multiple gearing and other intra-group creation of capital whereas, without appropriate adjustment, a legal entity focus may not. Whatever approach is used, multiple gearing and other intra-group creation of capital should be identified and treated in a manner deemed appropriate by the supervisor to largely prevent the duplicative use of capital. Leverage Leverage arises where a parent, either a regulated company or an unregulated holding company, issues debt or other instruments which are ineligible as regulatory capital or the eligibility of which is restricted and down-streams the proceeds as regulatory capital to a subsidiary. Depending on the degree of leverage, this may give rise to the risk that undue stress is placed on a regulated entity as a result of the obligation on the parent to service its debt. Page 4 of 77

5 Fungibility and transferability In the context of a group-wide solvency assessment, excess capital in an insurance legal entity above the level needed to cover its own capital requirements may not always be available to cover losses or capital requirements in other insurance legal entities in the group. Free transfer of assets and capital may be restricted by either operational or legal limitations. Some examples of such legal restrictions are exchange controls in some jurisdictions, surpluses in with-profits funds of life insurers which are earmarked for the benefit of policyholders and rights that holders of certain instruments may have over the assets of the legal entity. In normal conditions, surplus capital at the top of a group can be down-streamed to cover losses in group entities lower down the chain. However, in times of stress such parental support may not always be forthcoming or permitted The group-wide capital adequacy assessment should identify and appropriately address restrictions on the fungibility of capital and transferability of assets within the group in both normal and stress conditions. A legal entity approach which identifies the location of capital and takes into account legally enforceable intra-group risk and capital transfer instruments may facilitate the accurate identification of, and provision for, restricted availability of funds. Conversely an approach with a consolidation focus using a consolidated accounts method which starts by assuming that capital and assets are readily fungible/transferable around the group will need to be adjusted to provide for the restricted availability of funds. 3. EU DIRECTIVE ON SOLVENCY II: PRINCIPLES (LEVEL 1) Content that relates to the treatment of participations are reproduced below: From Article 92, titled Implementing measures in the OWN FUNDS section: 1. The Commission shall adopt implementing measures specifying the following: (a) ; (b) the treatment of participations, within the meaning of the third subparagraph of Article 210(2), in financial and credit institutions with respect to the determination of own funds. Those measures designed to amend non-essential elements of this Directive, by supplementing it, shall be adopted in accordance with the regulatory procedure with scrutiny referred to in Article 304(3). 2. Participations in financial and credit institutions as referred to in point (b) of paragraph 1 shall comprise the following: (a) participations which insurance and reinsurance undertakings hold in: (i) credit institutions and financial institutions within the meaning of Article 4(1) and (5) of Directive 2006/48/EC, (ii) investment firms within the meaning of point 1 of Article 4(1) of Directive 2004/39/EC; (b) subordinated claims and instruments referred to in Article 63 and Article 64(3) of Directive 2006/48/EC which insurance and reinsurance undertakings hold in respect of the entities defined in point (a) of this paragraph in which they hold a participation. Page 5 of 77

6 Article 216, titled Supervision of group solvency 1. Supervision of the group solvency shall be exercised in accordance with paragraphs 2 and 3, Article 250 and Chapter III. 2. In the case referred to in point (a) of Article 211(2), Member States shall require the participating insurance or reinsurance undertakings to ensure that eligible own funds are available in the group which are always at least equal to the group Solvency Capital Requirement as calculated in accordance with Subsections 2, 3 and In the case referred to in point (b) of Article 211(2), Member States shall require insurance and reinsurance undertakings in a group to ensure that eligible own funds are available in the group which are always at least equal to the group Solvency Capital Requirement as calculated in accordance with Subsection 5. From Article 220, titled Elimination of double use of eligible own funds 1. The double use of own funds eligible for the Solvency Capital Requirement among the different insurance or reinsurance undertakings taken into account in that calculation shall not be allowed. For that purpose, when calculating the group solvency and where the methods described in Subsection 4 do not provide for it, the following amounts shall be excluded: (a) the value of any asset of the participating insurance or reinsurance undertaking which represents the financing of own funds eligible for the Solvency Capital Requirement of one of its related insurance or reinsurance undertakings; (b) the value of any asset of a related insurance or reinsurance undertaking of the participating insurance or reinsurance undertaking which represents the financing of own funds eligible for the Solvency Capital Requirement of that participating insurance or reinsurance undertaking; (c) the value of any asset of a related insurance or reinsurance undertaking of the participating insurance or reinsurance undertaking which represents the financing of own funds eligible for the Solvency Capital Requirements of any other related insurance or reinsurance undertaking of that participating insurance or reinsurance undertaking. 5. Any eligible own funds of a related insurance or reinsurance undertaking of the participating insurance or reinsurance undertaking for which the group solvency is calculated that are subject to prior authorisation from the supervisory authority in accordance with Article 89 may only be included in the calculation in so far as they have been duly authorised by the supervisory authority responsible for the supervision of that related undertaking. Article 221, titled Elimination of the intra-group creation of capital 1. When calculating group solvency, no account shall be taken of any own funds eligible for the solvency capital requirement arising out of reciprocal financing between the participating insurance or reinsurance undertaking and any of the following: (a) a related undertaking; (b) a participating undertaking; (c) another related undertaking of any of its participating undertakings. 2. When calculating group solvency, no account shall be taken of any own funds eligible for the Solvency Capital Requirement of a related insurance or reinsurance undertaking of the participating insurance or reinsurance undertaking for which the group solvency is calculated when the own funds concerned arise out of reciprocal financing with any other related undertaking of that participating insurance or reinsurance undertaking. Page 6 of 77

7 3. Reciprocal financing shall be deemed to exist at least when an insurance or reinsurance undertaking, or any of its related undertakings, holds shares in, or makes loans to, another undertaking which, directly or indirectly, holds own funds eligible for the Solvency Capital Requirement of the first undertakings. Article 226, titled Related credit institutions, investment firms and financial institutions When calculating the group solvency of an insurance or reinsurance undertaking which is a participating undertaking in a credit institution, investment firm or financial institution, Member States shall allow their participating insurance and reinsurance undertakings to apply mutatis mutandis methods 1 or 2 set out in Annex I to Directive 2002/87/EC. However, method 1 set out in that Annex shall be applied only if the group supervisor is satisfied as to the level of integrated management and internal control regarding the entities which would be included in the scope of consolidation. The method chosen shall be applied in a consistent manner over time. Member States shall however allow their supervisory authorities, where they assume the role of group supervisor with regard to a particular group, to decide, at the request of the participating undertaking or on their own initiative, to deduct any participation as referred to in the first paragraph from the own funds eligible for the group solvency of the participating undertaking. Article 227, titled Non-availability of the necessary information Where the information necessary for calculating the group solvency of an insurance or reinsurance undertaking, concerning a related undertaking with its head office in a Member State or a thirdcountry, is not available to the supervisory authorities concerned, the book value of that undertaking in the participating insurance or reinsurance undertaking shall be deducted from the own funds eligible for the group solvency. In that case, the unrealised gains connected with such participation shall not be recognised as own funds eligible for the group solvency. Article 231, titled Method 2 (Alternative method): Deduction and aggregation method. 2. The aggregated group eligible own funds are the sum of the following: (a) the own funds eligible for the Solvency Capital Requirement of the participating insurance or reinsurance undertaking; (b) the proportional share of the participating insurance or reinsurance undertaking in the own funds eligible for the Solvency Capital Requirement of the related insurance or reinsurance undertakings. 4. Where the participation in the related insurance or reinsurance undertakings consists, wholly or in part, of an indirect ownership, the value in the participating insurance or reinsurance undertaking of the related insurance or reinsurance undertakings shall incorporate the value of such indirect ownership, taking into account the relevant successive interests, and the items referred to in points (b) of the second and third paragraphs shall include the corresponding proportional shares of the own funds eligible for the Solvency Capital Requirement of the related insurance or reinsurance undertakings and of the Solvency Capital Requirement of the related insurance or reinsurance undertakings, respectively. Page 7 of 77

8 Article 92 of the SAM primary legislation is the same Article 92 from the Level 1 text above, except that references to articles and directives were replaced by SAM-specific references. Alternatively, the reference was replaced by phrases of the form as shall be determined by the FSB (or as prescribed in the subordinate legislation). 4. MAPPING ANY PRINCIPLE (LEVEL 1) DIFFERENCES BETWEEN IAIS ICP & EU DIRECTIVE Section 3 of the Solvency II Level 1 principles does not go into as much detail as Section and Section of ICP 17 ( Capital Adequacy ), but also does not contradict any of the principles stated by the IAIS. 5. STANDARDS AND GUIDANCE (LEVELS 2 & 3) 5.1 IAIS standards and guidance papers There are several principles in other IAIS documents that could indirectly affect the treatment of participations in an insurer s own funds and solvency capital requirement. For example, the topics of group supervision, non-regulated entities, financial conglomerates, systemic aspects, off-balance sheet exposures, liquidity risks, diversification/concentration, contagion and reputational risk are all mentioned in other IAIS documents. These sections were omitted from this discussion document because it would be covered by other discussion documents and is outside the scope of this document. 5.2 CEIOPS CPs (consultation papers) and EIOPA guidance CEIOPS Principles CEIOPS Advice for Level 2 Implementing Measures on Solvency II titled Treatment of participations (CEIOPS-DOC-63/10, former Consultation Paper 67) aims at providing advice on the treatment of participations for the determination of own funds as required in Article 92 of the Solvency II Level 1 text. The CEIOPS paper contains detail on the options considered and the majority and minority views in respect of the preferred approaches. A brief summary of CEIOPS advice is given below. CEIOPS Members considered the following objectives to be relevant when considering the treatment of participations. a) Double gearing (example given in the paper). b) Ensure that capital in each solo entity corresponds to the risk run in that entity. c) Limit systemic risk. d) Avoid contagion of risk within a group through subsidiaries/participations. Even though the assessment may be done at group level, this is also relevant at solo level. e) Avoid incentives to regulatory arbitrage through group structuring. Some of these objectives will relate to both the solo and group treatment of participations, depending on the structure of the (re)insurance undertaking. Page 8 of 77

9 Financial and Credit Institutions The majority view of CEIOPS members was that own funds from financial and credit institutions should not be recognised as eligible own funds. This was based on two arguments: Identifying the SCR equivalent in these participations may be too complex; and Any surplus capital may be subject to restrictions and thus own funds of such entities may not be available to absorb losses in the parent There were concerns that this approach is overly penal and thus there was a minority view that financial and credit participations should be treated as equity investments at solo level and thus be subject to the normal equity risk SCR charge. (Re)insurance Participations The vast majority of members considered that, of own funds which arise from (re)insurance participations, at least the amount corresponding to the participation s SCR is not available to absorb losses in the parent. Thus the amount equal to the participation s SCR should be treated as a restricted item and excluded on a proportional basis from the parent s own funds ( 6.10). Furthermore, any inherent goodwill in the valuation should be excluded from own funds of the participating undertaking ( 6.12). Finally, the excess of own funds over SCR (in the participation) should be tested to determine whether it provides loss absorbency capacity to the parent ( 6.13). Under CEIOPS approach the parent would allow for the value of the participation s own funds less SCR in the parent s own funds. This implies that any difference between the value placed on the participation and attributable own funds less SCR is excluded from the parent s own funds. The CEIOPS minority view was that all participations should be addressed under the equity risk module, possibly with a reduction in the equity risk charge for strategic participations (suggested at 50%). This is the approach that was followed in QIS5 (and SA QIS1). An investment in a (re)insurance participation may expose the parent to other risks besides equity risk. This is not reflected directly in the SCR of the parent under the latter approach, as discussed in CEIOPS-DOC-63/10 A4. The CEIOPS majority view approach allows for the risks associated with (re)insurance participations through a reduction in own funds ( ). The majority view also provides an approach using the SCR ( 6.15) in annex A. The details of this are as follows: The participations risk module is added to the BSCR. Alternatively, participations could be considered in the equity risk sub-module but with correction factors to allow for the associated issues (re double gearing and diversification). ( A.1) The stress to the value of the participation is the SCR. Furthermore, any inherent goodwill in the valuation of the participation caused by a mark-to-market vs. a Solvency II net asset approach must be addressed through the intangible assets risk module. ( A.2) Financial Non-regulated Participations The CEIOPS view was that these participations should be treated consistently with regulated financial and credit participations. Under the majority view this would exclude the value of the participation from the parent s own funds for purposes of solo reporting. Non-Financial Non-regulated Participations Page 9 of 77

10 The CEIOPS view was that these participations should be treated as normal equity investments CEIOPS Conclusion In giving their advice, CEIOPS members consider all the key regulatory objectives to be relevant when considering the treatment of participations. CEIOPS is of the opinion that the same method should apply regardless of whether the related undertaking is a subsidiary or participation. The proposed treatments are presented based on whether the participation is included in or excluded from the group and are also by the nature of the participation. Consequently CEIOPS proposes the following with respect to the solo treatment of participations for the determination of own funds. Note that the solo treatment varies depending on whether the participation is included in the scope of the parent s group supervision. For participations included in the scope of group supervision Regulated Financial and credit institutions Own Funds - Do not recognise own funds (or ancillary own funds) arising from the participation. (Re)insurers - Exclude amount of participation s own funds required to meet its own SCR. - Exclude inherent goodwill of participation. - The characteristics of the remaining own funds should be tested to decide on further restrictions or the Tier in which it should fall. (An alternative approach is to relegate own funds to Tier 3 and make an appropriate adjustment to the SCR formula) Unregulated Related to the financial sector Not related to the financial sector - Do not recognise own funds (or ancillary own funds). - Include at market value For participations excluded from the scope of group supervision If the participation is also excluded from assessment of the solo solvency position, then the amount should not be recognised as eligible own funds. If the participation is included in the assessment of the solo solvency position, treat the participation as if it were included in the scope of group supervision EIOPA Technical Specifications: On 21 December 2012, EIOPA released the Revised Technical Specifications for the Solvency II valuation and Solvency Capital Requirements calculations, or EIOPA-DOC- 12/467. The preamble to this introduces it as a working document to be used by industry as a guide to the quantitative assessment required under Solvency II while political discussions Page 10 of 77

11 are on-going. It is informed by the Omnibus 2 Directive, various working documents on the Solvency II implementing measures, and EIOPA s own work in the development of the technical standards. EIOPA-DOC-12/467 therefore does not represent the final Solvency II technical specifications. It does however contain valuable information regarding the possible final requirements. The following sections of EIOPA-DOC-12/467 are relevant to the treatment of participations in Solvency II: Paragraph V.8 on pages 8 9, which discusses the valuation of participations, Section SCR.14 on pages (Solo treatment of participations), and Section SCR.5.9 on pages (treatment of participations in the concentration risk module). Parts of these are reproduced below. Valuation of participations ( V.8) Holdings in related undertakings are to be valued at the quoted market price in an active market. If this valuation is not possible: 1. Holdings in insurance and reinsurance undertakings a. Subsidiary undertakings have to be valued with the equity method that is based on a Solvency II consistent recognition and measurement for the subsidiary s balance sheet. b. Related undertakings, other than subsidiaries, would also be valued with the equity method using a Solvency II consistent recognition and measurement for the holding s balance sheet. However, if this is not possible, an alternative valuation method in accordance with the requirements in V1.1 and V1.2 should be used. 2. Holdings in undertakings other than insurance and reinsurance undertakings a. Holdings in undertakings other than insurance and reinsurance undertakings have to be valued with the equity method that is based on a Solvency II consistent recognition and measurement for the subsidiary s balance sheet. If that is not practicable, the equity method would be applied to the related undertaking s balance sheet following IFRSs as endorsed by the European Commission with the amendment that goodwill and other intangible assets would need to be deducted. If this is not possible for related undertakings, other than subsidiaries, an alternative valuation method in accordance with the requirements in V1.1. and V1.2 should be used. Section V.1.4 ( Consistency of [IFRSs] with Article 75 ) of EIOPA-DOC-12/467 provides guidance on the interpretation the equity method (which is from IAS28): Page 11 of 77

12 IAS 28 prescribes the accounting for investments in associates and to set out the requirements for the application of the equity method when accounting for investments in associates and joint ventures. Associates are accounted for using the equity method. The equity method is a method of accounting whereby the investment is initially recognised at cost and adjusted thereafter for the post-acquisition change in the investor s share of the investee s net assets. The investor s profit or loss includes its share of the investee s profit or loss and the investor s other comprehensive income includes its share of the investee s other comprehensive income. The investor s share of the profit or loss of the investee is recognised in the investor s profit or loss. Distributions received from an investee reduce the carrying amount of the investment. Adjustments to the carrying amount may also be necessary for a change in the investor s proportionate interest in the investee arising from changes in the investee s other comprehensive income. Such changes include those arising from the revaluation of property, plant and equipment and from foreign exchange translation differences. The investor s share of those changes is recognised in other comprehensive income of the investor (see IAS 1 Presentation of Financial Statements (as revised in 2007)). (IAS 28.11). The entity s financial statements shall be prepared using uniform accounting policies for like transactions and events in similar circumstances (IAS 28.26). If an associate or joint venture uses accounting policies other than those of the entity for like transactions and events in similar circumstances, adjustments shall be made to conform the associate s or joint venture s accounting policies to those of the entity when the associate s financial statements are used by the entity in applying the equity method (IAS 28.36). Solvency II framework: When calculating the excess of assets over liabilities for related undertakings, other than related insurance and reinsurance undertakings, the participating undertaking shall value the related undertaking's assets and liabilities in accordance with the equity method as prescribed in international accounting standards, as endorsed by the Commission in accordance with Regulation (EC) No 1606/2002, where valuation in accordance with Articles 75 to 86 of Directive 2009/138/EC is not practicable. In such cases the value of goodwill and other intangible assets valued at zero shall be deducted from the value of the related undertaking. Solo treatment of participations ( SCR.14) EIOPA-DOC-12/ discusses the identification of participations, their valuation, and their treatment in the calculation of the SCR under Solvency II. Identification of participations The text quoted below defines how (re)insurers should assess whether a holding is classified as a participation. Page 12 of 77

13 SCR Characteristics of a participation SCR A participation is constituted by share ownership or by the exertion of a dominant or significant influence over another undertaking. The following paragraphs describe how both types of participation can be identified. SCR The identification is based on an assessment from a solo perspective. SCR Participations by virtue of share ownership SCR When identifying a participation based on share ownership, directly or by way of control, the participating undertaking has to identify (i) (ii) its percentage holding of voting rights and whether this represents at least 20% of the potential related undertaking s voting rights and its percentage holding of all classes of share capital issued by the related undertaking and whether this represents at least 20% of the potential related undertaking s issued share capital. Where the participating undertaking s holding represents at least 20% in either case its investment should be treated as a participation. SCR Where the participation is in an insurance or reinsurance undertaking subject to Solvency II, the assessments under SCR.14.4 (i) relate to paid-in ordinary share capital referred to in OF.4 (i) and under SCR.14.4 (ii), to paid-in ordinary share capital referred to in OF.4 (i) and paid-in preference shares. SCR Participations by virtue of the exertion of dominant or significant influence SCR When identifying a participation on the basis that the participating undertaking can exert a dominant or significant influence over another undertaking, the following factors have to be considered: (i) (ii) (iii) (iv) (v) (vi) (vii) current shareholdings and potential increases due to the holding of options, warrants or similar instruments representation on the administrative, management or supervisory board of the potential related undertaking involvement in policy-making processes, including decision making about dividends or other distributions material transactions between the participating undertaking and potential related undertaking interchange of managerial personnel provision of essential technical information membership of a mutual undertaking where that membership is sufficiently large to be non-homogeneous when compared to that of other members Identification of a participation in a financial and credit institution (F&CI) The text quoted below defines how (re)insurers should assess whether a particular participation is categorised as an F&CI participation. Additional information relating to this is included in appendix 8.1. Page 13 of 77

14 SCR Participations in financial and credit institutions SCR.14.8.Undertakings should treat a related undertaking as a financial and credit institution, where it is an institution listed or described in accordance with Article 4(1) and (5) of Directive 2006/48/EC or Article 4(1) of Directive 2004/39/EC. Any institution which performs the functions or carries out the business described pursuant to those Articles should be treated as a financial and credit institution notwithstanding that it may not be subject to the Directives, either because it is a third country undertaking or otherwise out of scope. SCR Any participation in a financial and credit institution held indirectly is treated in the same way as a directly held participation in a financial and credit institution. Identification of strategic participations The text quoted below defines how (re)insurers should assess whether a particular participation is categorised as a strategic participation. SCR Strategic participations SCR An equity investment is of a strategic nature if the following criteria are met: (i) The value of the equity investment is likely to be materially less volatile for the following 12 months than the value of other equities over the same period as a result of both the nature of the investment and the influence exercised by the participating undertaking in the related undertaking. (ii) the nature of the investment is strategic, taking into account all relevant factors, including: (a) the existence of a clear decisive strategy to continue holding the participation for [a] long period (b) the consistency of the strategy referred to in point (a) with the main policies guiding or limiting the actions of the undertaking (c) the participating undertaking s ability to continue holding the participation in the related undertaking (d) the existence of a durable link (e) where the insurance or reinsurance participating company is part of a group, the consistency of such strategy with the main policies guiding or limiting the actions of the group Treatment of non-f&ci participations in the SCR / OF calculation The text quoted below discusses the treatment of participations other than financial and credit institutions under Solvency II. Page 14 of 77

15 SCR Treatment of participations, other than in financial and credit institutions, in the calculation of the Solvency Capital Requirement with the Standard Formula SCR The calculation of the Solvency Capital Requirement in accordance with the standard formula for participations in undertakings other than financial and credit institutions, does not require the aggregation of the investment in own funds items in respect of each participation. The equity risk charge relevant to the investment in ordinary or preference share capital of the related undertakings is determined independently from the application of the relevant risk charges (e.g. interest, spread, concentration, currency) to any investment in subordinated liabilities of the related undertaking, which is treated as a bond. SCR When applying the standard formula to the equity and subordinated liability components of a participation, the undertaking has to: (i) (ii) (iii) apply the interest and spread risk sub-modules set out in subsection SCR.5.5. and SCR.5.9. relevant to bonds to holdings of subordinated liabilities apply the relevant equity risk charges to equity holdings as set out in subsection SCR.5.6. apply additional market risk sub-modules, such as currency, as appropriate Note that the treatment of equity investments in a strategic participation differs from the treatment of those in a non-strategic participation ( SCR.5.40): Equity investments in strategic participations have a stress of 22% applied to them. No justification for or derivation of this figure could be found. A possible derivation is as 50% of the average of the Type 1 and Type 2 stresses (cf. the CEIOPS minority opinion in section 5.2.1). Equity investments in non-strategic participations have a standard Type 1 or Type 2 stress applied to them. These are 39% and 49% (pre symmetric adjustment) respectively. Treatment of F&CI participations in the SCR / OF calculation The text quoted below discusses the treatment of participations that are financial and credit institutions under Solvency II. Page 15 of 77

16 SCR Treatment of participations in financial and credit institutions in the calculation of Own Funds SCR When calculating the value of a participation, in order to assess whether the deductions set out in SCR or SCR apply, the undertaking has to consider holdings of both equity and any other own-fund items held in the related undertaking by the participating undertaking. SCR The deductions and other treatments in respect of financial and credit institutions are set out in Annex V. SCR The basic own funds have to be reduced by the full value of each participation in a financial and credit institution that exceeds 10% of items listed in OF.4. SCR The basic own funds have to be reduced by the part of the aggregate value of all participations in financial and credit institutions, other than participations dealt with under SCR , that exceeds 10% of items listed in points OF.4. SCR In calculating the 10% of items listed in OF.4. the amount of own-funds items before any deduction set out in SCR or SCR is used. SCR Notwithstanding SCR and SCR , there is no deduction for strategic participations which are included in the calculation of the group solvency on the basis of method 1 as described in subsection G.1.1. SCR Deductions according to SCR are applied on a pro-rata basis to all participations referred to in that paragraph. SCR Deductions included in paragraphs SCR and SCR are made from the corresponding tier in which the participation has increased the own funds of the related undertaking as follows: (i) (ii) (iii) holdings of Common Equity Tier 1 items of financial and credit institutions have to be deducted from the items listed in OF.4. holdings of Additional Tier 1 instruments of financial and credit institutions have to be deducted from the items listed in OF.39. holdings of Tier 2 instruments of financial and credit institutions have to be deducted from the items listed in OF.40. SCR Where the items to be deducted are not classified into tiers, all deductions are made from the amount of items listed in OF.4. SCR Where the amount of the deduction exceeds the amount from which it is required to be deducted in accordance with SCR , the excess is deducted from higher quality items until the deduction is made in full. SCR In the calculation of the Solvency Capital Requirements amounts not deducted should be treated in accordance with subsection when an internal model is used and section SCR.5. when the standard formula is applied. Treatment of participations under an internal model The text quoted below discusses the treatment of participations where the (re)insurer uses an internal model. Page 16 of 77

17 SCR Treatment of participations in the calculation of the Solvency Capital Requirement with an internal model SCR The requirements set out in subsection SCR apply to firms using internal models in so far as any reduction of own funds set out in subsection SCR for holdings in financial and credit institutions has to be made. The treatment of holdings in financial and credit institutions not deducted in whole or part has to ensure that the requirements set out in Article 103 (3) of Directive 2009/138/EC are met. Treatment of participations in the concentration risk module ( SCR.5.9) The text quoted below relates to the treatment of participations in the concentration risk module. Page 17 of 77

18 SCR The scope of the concentration risk sub-module extends to assets considered in the equity, spread risk and property risk sub-modules, and excludes assets covered by the counterparty default risk module in order to avoid any overlap between both elements of the standard calculation of the SCR. SCR According to an economic approach, exposures which belong to the same group as defined in Article 212 of the Solvency II Framework Directive or to the same financial conglomerate as defined in Article 2(14) of the Financial Conglomerate Directive (2002/87/EC) should not be treated as independent exposures. The legal entities of the group or the conglomerate considered in the calculation of own funds should be treated as one exposure in the calculation of the capital requirement. SCR assets considered in the concentration risk sub-module should not include: 2. exposures an insurance or reinsurance undertaking has to a counterparty which belongs to the same group as the insurance or reinsurance undertaking, provided that the following conditions are met: (i) the counterparty is an insurance or reinsurance undertaking, an insurance holding company, a mixed financial holding company or an ancillary services undertaking which is subject to prudential requirements; (ii) the counterparty is fully consolidated in the same consolidation scope as the undertaking; (iii) the counterparty is subject to the same risk evaluation, measurement and control procedures as the undertaking; (iv) the counterparty is established in the Union; (v) there is no current or foreseen material practical or legal impediment to the prompt transfer of own funds or repayment of liabilities from the counterparty to the undertaking; 3. the value of the participations as defined in Article 92(2) of Directive 2009/138/EC in financial and credit institutions that are deducted from own funds; Special reference to participations SCR No capital requirement should apply for the purposes of this sub-module to exposures of undertakings to a counterparty which belongs to the same group as defined in Article 212 of Directive 2009/138/EC, provided that the following conditions are met: the counterparty is an insurance or reinsurance undertaking or a financial holding company, asset management company or ancillary services undertaking subject to appropriate prudential requirements; the counterparty is included in the same consolidation as the undertaking on a full basis; there is no current or foreseen material practical or legal impediment to the prompt transfer of own funds or repayment of liabilities from the counterparty to the undertaking. Summary In short: 1. For the valuation, a quoted market price in an active market should be used. Where this is not available the treatment depends on the type of undertaking: o (Re)Insurers: Page 18 of 77

19 The undertaking should be valued using the equity method on a Solvency II consistent basis. Thus it is recognised at cost plus the attributable profits (less losses), less any distributions. These profits (losses) should be as determined on a Solvency II consistent basis. Furthermore, goodwill should not be recognised so as to ensure Solvency II-consistency. Where the undertaking is not a subsidiary and it is not possible to value the undertaking on a Solvency II consistent basis, it should be valued in a manner consistent with the Solvency II treatment of assets. o Other undertakings: The undertaking should be valued using the equity method on a Solvency II consistent basis. Thus it is recognised at cost plus the attributable profits (less losses), less any distributions. These profits (losses) should be as determined on a Solvency II consistent basis. Furthermore, goodwill should not be recognised so as to ensure Solvency II-consistency. Where this is not practicable, the equity method applied to the IFRS balance sheet modified for goodwill and other intangible assets should be used to value the undertaking. Where the above are not possible and the undertaking is not a subsidiary, it should be valued in a manner consistent with the Solvency II treatment of assets. 2. There are two ways in which a related undertaking may be classified as a participation: o By virtue of share ownership, and o o o By virtue of the exertion of dominant or significant influence. A related undertaking is a participation by virtue of share ownership if the (re)insurer holds at least 20% of the potential voting rights or if the (re)insurer holds at least 20% of the undertaking s issued share capital. For Solvency II-regulated entities, the assessment of voting rights held considers only paid-in ordinary share capital (and not preference shares), i.e. only ordinary shares included in tier one. The assessment of share capital held includes paid-in preference shares, however. 3. Strategic participations are classified as such on the basis of lower volatility of the investment and the strategic nature of the investment (plan to hold for a long period, ability to hold for that period, etc.). No justification for or derivation of the 22% stress is provided, although it may relate to a minority opinion expressed in CEIOPS-DOC-63/ Treatment of non-f&ci participations in the SCR standard formula is captured through the market risk module, i.e.: o The application of the equity charge on the ordinary and preference share capital held; o The application of the interest and spread charges to liabilities held; and o The application of any remaining relevant market risk charges. 5. Treatment of FC&I participations: o Where a participation constitutes more than 10% of the (re)insurer s tier one own funds, the full value of that participation is removed from the (re)insurer s basic own funds. o Where any remaining F&CI participations exceed the 10% threshold in aggregate, the excess over that threshold is removed from the (re)insurer s basic own funds. This is done on a pro-rata basis. o o o There are requirements as to the tiers from which the above deductions are made. Amounts not deducted should be treated in line with the market risk module of the standard formula or the internal model of the (re)insurer, whichever is appropriate. The above attempts to ensure consistency between the treatment of banks under Solvency II and (re)insurers under Basel III (see of the revised Basel III capital requirements proposal). There are some differences, however. The Basel III specifications are therefore discussed in section o It should be noted that the treatment of F&CI participations proposed by EIOPA leads to a discontinuity where the participation exceeds 10% of tier one own funds. A small increase in the value of the participation (say from 9% to 11%) can result in a significant reduction in the (re)insurer s tier one own funds. 6. Treatment of participations in the concentration risk module: Page 19 of 77

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