CEIOPS- P1-15/07 Summary of the industry s contribution on the use of innovative instruments & supplementary members calls as eligible elements of capital August 2007 1
Table of contents Introduction...3 Innovative Instruments...3 Current situation...3 Future development...6 Supplementary members calls...7 Use of supplementary members' calls...7 Calling procedures of a supplementary call...8 Notification of calls procedure...9 Distribution of excess profits to members... 10 Inclusion in the solvency margin... 11 Rules for admission in eligible elements... 12 Deleted: 5 Deleted: 7 Deleted: 7 Deleted: 8 Deleted: 9 Deleted: 10 Deleted: 11 Deleted: 11 2
Introduction 1. In Autumn 2006, CEIOPS has published a questionnaire to collect the industry s views on the new trends and market conventions with regard to eligible capital, as well as the experience of mutuals with members calls. 1 This questionnaire was issued in order to prepare the ground for further developments of CEIOPS' advice on eligible elements of capital in the frame of the Solvency II project, especially in respect of future level 2 implementing measures and level 3 tools to enable further convergence of practice. The summary is based solely on the contribution of the industry and does not reflect supervisory views on the use of innovative instruments or members calls. 2. At the same time, a questionnaire on the implementation of the current insurance Directives with regard to eligible elements has been addressed to the supervisory authorities in order to gather their experience in the field of own funds. 2 3. CEIOPS would like to thank following companies and trade associations for their participation to the survey: Association of Hungarian Insurance companies, Aviva, Britannia Steam Ship Insurance Association Ltd, Caisse Mutuelle Marnaise d'assurance (MAF), DEVK,Ethias, GARD, Generali, GDV, Kobstaedernes Forsikring, KPA Pension, Liverpool Victoria, Mutuelle d Assurance des Instituteurs de France (MAIF), MACSF, Morgan Stanley, Munich Re, Mutuelle Alsace Lorraine, Mutuelle de Poitiers, Prudential, Reale Mutua Assicurazioni (REMA), Shipowners, Skuld, SMABTP, Steamship Insurance Management Services Strike Club, The London P&I Club, The Standard, The Swedish Club and West of England Insurance Services. Innovative Instruments Current situation 4. In general, when it comes to issuing innovative instruments as eligible capital, the respondents reported that either they have no experience in 1 November 2006, http://www.ceiops.org/media/files/consultations/ceiops-sec-74-06questionnaireeligibleelemcap.pdf 2 Report on the implementation of the current insurance directives with regard to the eligible elements to meeting the solvency margin, CEIOPS- P1-14/07, August 2007. 3
the issuing of innovative instruments or are critical with regard to limitations in the regulation applying to these instruments. 5. Innovative instruments that have reached a reasonable market standing in the insurance industry are being described as to share the following features: undated or very long dated typically with call and step-up optional or mandatory (pre-defined trigger) interest deferral non cash-cumulative deep subordination 6. The kinds of innovative instruments respondents named as having a reasonable market standing are structured notes, contingent surplus notes and super-subordinate securities. The trend in innovative instruments with a capital function has been towards perpetual debt-based structures that either incorporate a noncumulative deferral or an Alternative Coupon Settlement Mechanism. 7. The main drivers for issuance are regulatory change and the treatment of these elements by the rating agencies. Issuance of these instruments increases in MS where revised regulatory guidelines render high quality (without limits, tier 1) regulatory capital recognition possible or in anticipation of possible future revisions of regulatory guidelines in some MS. When issuing hybrid capital, insurance companies would also seek to conform to the requirements of leading rating agencies for equity recognition. 8. The main reasons stated for using innovative instruments are that they provide funding in a format which represents regulatory capital and achieves beneficial treatment by the rating agencies through instruments which are not dilutive and mostly have a tax-deductible coupon. They also optimize the capital structure of insurance companies by reducing the cost of capital since they involve lower cost than genuine equity and finally they expand the possible sources of tier 1 capital through the capital markets and diversify the potential investor base by tapping new groups of investors. 9. Stakeholders identify several factors that govern the issuance of innovative instruments. The main of which are cost, regulation and rating agencies guidelines. Further factors are the diversification of funding, capital structure optimization, liquidity, sponsors requirements and their role, documentation, market perception, accounting and tax treatments and particular risk profiles. Group issues may also play a role as well as corporate spread levels and the general market environment. 4
10.The main market conventions to rule the issuance of innovative instrument are given as step ups with a limit of 100bps accepted by both banking regulators and rating agencies, coupons that typically switch from fixed to floating after the first call date, coupon pushers/dividend stoppers that ensure that interest cannot be deferred when dividends are paid and fixed claims of seniority relative to shareholders in liquidation. Institutional investors are also said to demand higher premiums for the ability to convert claims into preference shares and to require tax, regulatory and rating agency calls. 11.Credit risk and legal risk are the main risks associated by stakeholders with the new instruments from the perspective of the investor. The risk that interest is deferred is another investors risk. One stakeholder points out that while the market is likely to forgive a deferral of interest if a company is under substantial financial stress, a decision to defer interest by a financially relatively healthy undertaking would probably produce a negative market reaction. Supervisors should take this possible market impact into consideration and have the power to prevent a deferral where the financial situation of an issuer does not justify it. There is also a risk that the inherent risk is not adequately reflected in the spread levels. One stakeholder holds the view that the respective risks depend on the chosen design which is affirmed by another who thinks that almost all recognised risks can be incorporated into an innovative structure. The risk of change in the regulatory or rating framework or the tax or accounting treatment following the issue date is seen as a risk from the perspective of the issuer if no grandfathering rights were granted. Another perceived risk for the issuer is the very high price of the instruments in those cases where the issuer really is in need of them. There is also felt to be a major risk associated with innovative instruments that applies to the entire market: the increasing presence of unsupervised corporate issuers into the hybrid market is believed to result in an increased volatility of the market through the higher risk to the securities of these unsupervised entities. This might have an effect on future developments. 12.Stakeholders have three key concerns regarding the supervisory approach to innovative instruments. These are a lack of harmonisation between different financial services companies, different supervisory treatment across Europe owing to overly national discretion in implementing European capital standards and regulatory constraints in structuring the issuance of innovative instruments. Although they are worried about a possible lack of convergence in the supervisory approach, respondents offer no view on what main differences in this respect have the most important impact on the structure and quality of own funds. 5
Future development 13.Stakeholders find it difficult to offer predictions as to the characteristics of innovative instruments in the future since prospective developments are seen to be mainly driven by rating agencies and regulators. Insofar as opinions are advanced respondents expect a continuance of the current trend, i. e. that instruments will be designed to meet certain regulatory as well as rating agencies requirements. In this context some stakeholders anticipate capital-like features such as strong mandatory deferral features or additional restrictions on redeeming instruments to be important in some structures. 14.The future development of innovative instruments in the view of one respondent will depend on the stability, consistency and sensibility of the framework of applicable rules. Another stakeholder expresses the opinion that the framework should not only be clear and flexible enough so that future developments can be taken into account, but also be based on principles rather than descriptive guidelines in order to offer the greatest adaptability across Europe in view of the significantly different legal frameworks. 15.With regard to the supervisory approach to innovative instruments stakeholders expect the supervisory modus operandi to be stable, consistent, sensible and considerate of the long-term nature of hybrid capital instruments which has the issuer dependant on reliable guidance as to the treatment of the instrument at the time of issue. The supervisory approach should be implemented in an appropriate manner and supervisory staff should be able to answer questions and to issue confirmations at short notice as the time frame for such transactions is sometimes rather tight. 6
Supplementary members calls Use of supplementary members' calls The responses show that supplementary members calls fall into two main broad categories: budgeted supplementary members calls and unbudgeted supplementary members calls. Budgeted supplementary members calls 16.The use of budgeted supplementary members calls appears to depend largely on the mutual insurance undertaking s business model (for example, fixed premium concept versus variable premium concept). 17.Not all undertakings use budgeted supplementary members calls, while for other undertakings, budgeted supplementary members calls are part of the annual process of setting premiums (for example, to avoid buying reinsurance instead). As such, they are annual deferred premiums which are part of the ongoing premiums charged. 18.Indeed, some undertakings reported that the use of budgeted supplementary members calls is contrary to their business policy, because, under their impression, they imply that the ongoing premiumsetting process is flawed. These undertakings adapt the annual premiums taking these budgets into account. Where budgeted supplementary members calls are used, it appears that, in some years, rebates can also arise. Unbudgeted supplementary members calls 19.On the whole, unbudgeted supplementary members calls are viewed as a means of absorbing unexpected losses due to specific circumstances in a given period. As such, they are viewed as a fundamental concept for mutual insurance undertakings, where, in a crisis, the collective of policyholders can be tapped for funding: an essential, but exceptional tool, particularly with a view to the fact that many mutual insurance undertakings have limited access to capital markets and, therefore, rely on supplementary members calls, when funds are needed. To the extent received, calls provide full loss absorption within a short period of time. 20.Many undertakings reported using unbudgeted supplementary members calls on an incidental basis. Some undertakings have never made, or have very rarely made, unbudgeted supplementary members calls. No undertakings have reported resorting to regular calls to enhance the solvency ratio. 7
21.According to the respondents, the amount actually received varies, largely, between 98% and 99.95% of the amount called. One undertaking reported a figure of 92+%; based on all of the information received, this collection rate appears to represent an outlier. 22.The information received does not suggest that non-receipt, or termination of contract as a result, is a real problem. 23. No sufficiently relevant information on the solvency ratio before and after the supplementary call has been received from the respondents. Calling procedures of a supplementary call Calling Procedure 24. In general, most mutuals treat a supplementary call as a call for additional premium. 25. The decision for a call falls in all cases under the responsibility of the mutual's Board of Directors who will either take the decision in their annual meeting, or if and when it becomes necessary. During the meetings, the Board will also fix the percentage of the subscription (the call rate and the level of the call) to be called back; one participant states that this is limited to one annual premium. 26. Immediately following the meeting, the decisions will be announced and communicated to the members and brokers through a written notification circular which, in some cases, will include the invoice. Time horizon for collection 27. The collection period is usually within one year after the decision in which the call has been approved. This is usually split in one, or more which is almost always the case installments, the first one due immediately. 28. When there is only one installment, this is usually due immediately, or over 4 weeks to 30 days or even the first semester of the calendar year; however, participants indicate that in most cases it usually takes one year for full collection. 29. In general, budgeted supplementary calls' payments are collected in one or two installments whereas for unbudgeted calls, the payments are usually collected in two or more installments. 8
Probability of default 30. Payment of the supplementary call is compulsory for all members. In general, given the quality of the mutual's membership, no significant default would be anticipated based on the assumption that 98% - 99% will be collectable. Most undertakings indicate that this in fact is close to 100%. 31. One participant indicates that when the call is fixed, default probability is assessed on a judgmental basis by applying a default ratio. 32. In minor cases, some undertakings indicate that they use a procedure similar to bad debt where experience indicated that bad debt write-offs should average less than 1% of gross premium debited. 33. Some participants have indicated the lack of experience in this field but stated that they would assume that the default probability is higher than the non-payment of premiums. Consequences of non-payment 34. As previously mentioned, no significant default would be anticipated given the quality of the membership. However, in case of non-payment of a call, the mutual will act in the same way as in the case of non-payment of the normal contributions (premiums); this only occurs in rare cases as payment of the supplementary calls is stipulated in the general terms of the Members' statutes (contracts). 35. In case of non-payment, Members risk facing premium recovery measures. Means to enforce payment include: a. Write-off against claims; b. Refuse payment of any claim for that member; c. Termination of Member's cover / contract; in this way, members will be unable to trade which is therefore a powerful sanction; d. Pursued for payment in courts; e. In the case of marine mutual insurance, arrest vessel to obtain security for the unpaid premium Notification of calls procedure 36. The possibility of a supplementary call and the procedure followed when this occurs is mentioned and described in the Articles of Association of the mutual as well as in all the contractual terms of the company statute which the Member has to sign. 37. In one case it is mentioned that the member's policy also specifies the maximum possible supplementary call. 9
38. Despite the fact that this possibility is mentioned in the Articles of Association, additional information will be announced and communicated to the members and brokers through a written notification circular, immediately following the meeting of the Board of Directors of the mutual, during which a supplementary call has been decided. 39. One participant mentioned that this information is also included in the mutual's news magazine which is sent to its members. Distribution of excess profits to members 40. The process of distribution of excess profits, if any, to members is also described in the Articles of Association. Even though this is an option, it very rarely occurs and most of the participants mention that this has either only happened once in the past or they have not distributed excess profits in a very long time, at least not in the last 5 to 25 years. 41. Usually, the Mutuality Commission (consisting of members of the Board) formulate a plan for distribution and submit it to the mutual's Board of Directors. The Board in turn will approve it and send it to the General Assembly - or, as one participant indicates, to the General Members Meeting and in turn to the Supervisory Authority which can, for valid reasons, exercise a veto - which will establish the amount. 42. This amount could be either a proportion to the contributions that the members originally made; or a percentage of the last five years premium, only of the lines of business or contracts which were profitable. 43. In order for a member to be eligible to any excess profit distribution, he or she has to comply with the following: Have been a member before the beginning of the year where the excess profit has been realised; The premiums due need to have been fully paid for; and Still be a member when the distribution is actually carried-out. 44. Excess profits can be distributed to members in the following ways: Free increase of the guarantees granted; Reduction in the following premiums to be called; Reduction of the premiums for non-life contracts; Increase of the sum assured for life contracts; Sometimes excess profits are calculated on the earnings of a particular branch, which is different from the total earning statement of a company. 45. A minority of the undertakings indicates that paying-out excess profits is not allowed, with one of them justifying it by stating that members 10
participate on the annual results via a no-claims-bonus. In these cases, excess funds are used by the mutual for internal purposes: Transferred to reserves brought forward in the next financial year; To offer insurance products at a reduced rate; To increase the capital of the mutual; To increase bonuses. Inclusion in the solvency margin 46. Article 16 of the amended Non-life Directive 73/239/EEC as amended by Article 1 2002/13/EC states that any claim the mutual has against its members by way of a call for supplementary contribution, within the financial year, is limited to up to one half of the difference between the maximum contributions and the contributions actually called in, and subject to a limit of 50% of the lesser of the available solvency margin and the required solvency margin. The article also mentions that the competent national authorities should establish guidelines stating the conditions under which supplementary contributions may be accepted. 47. In general, participants include supplementary calls in their available solvency margin usually every year, subject to a limit of 50% of the required solvency margin. The percentage limit of the available solvency margin depends on the financial situation of the company, usually ranging from 10 to 55% or up to half the difference between the maximum calls and the calls actually made. 48. Some participants have indicated that they do not need to include supplementary calls in their solvency margin as they have sufficient capital; however, they are keen to have the possibility of using it in the future as even though they are well capitalised now, they might not be under Solvency II. In one reported case, the mutual does not use this instrument as it is not foreseen in its statute. 49. In some cases, mutuals are not currently using supplementary calls in their solvency margin but have obtained permission from the supervisory authority to do so in the future. The authority granted them with a waiver subject to the call limited to half of the difference between the maximum calls and the calls actually made, subject to a limit of 50% of the total capital resources requirement. 50. Most undertakings, except in one case, were keen to have the option of using supplementary calls in the future when in need of capital. 11
Rules for admission in eligible elements 51. The responses to the questionnaire confirm that mutuals are in favour of creating rules for admission of potential supplementary calls in eligible elements to cover capital requirements. This is because although a company may be well capitalised under today's regulations, this will not necessarily be the case under Solvency II. Thus, in the long run, there is a possibility that even fixed premiums mutual companies might consider switching into variable ones; supplementary calls could be used as an opportunity to smooth the gap between mutual and stock companies. 52. Respondents from the German insurance industry appear to be in favour of economically principles-based rules for admission of these calls in eligible elements, with a view to enhance harmonisation among MS. With the ongoing convergence in financial services, there should be as little difference as possible in the eligible capital. A suggestion would be that the future Solvency II Directive would define criteria for admission of these potential calls, in order to allow automatic eligibility when these conditions are fulfilled. 53. Undertakings also argue that it will be inappropriate to use past market data and statistics as these calls are an exceptional solution and are not considered to be a normal and usual management tool. They suggest that the focus should be on the regulations and articles of association to rule the supplementary calls under Solvency II instead of relying on past statistics. 54. Some other suggestions from other undertakings include: i. The established rule for supplementary calls would be satisfactory. The fact that one keeps 50% of the supplementary members calls takes into account the eventual tax raising and the probability of the failings of a part of the members. ii. It would be more relevant to take into account the supplementary call for contributions in the calculation of the SCR, rather than considering it as an eligible element to cover the SCR, as this would reduce the volatility of the underwriting risk. If this is not the case, then mutuals that have a real experience and a document history should be permitted to integrate a percentage of their written premiums (10% according to them) in tier 1; this would come in deduction of the call set in tier 2. 55. Whatever the option or rules, the Mutual should inform their members on the supplementary calls in the following ways: Only general principles (without any calculations) should be explained; 12
Inscription of the principle of the supplementary call in the annual report; Inscription in the insurance contracts/policies, the general conditions/terms, the bylaws/articles of association when members join the mutual; Inscription of the potential amount of the call (for example, x% time the amount of the ordinary contribution); Description of the circumstances in which the call can be implemented and the consequences of the refusal to pay. ********* 13