1. Rules on Own Funds admitted to cover the capital requirements Bakιda, Azәrbaycanιn paytaxtι -- Üçüncü gün 14 mart 2012 ACP -- Élie Sibony, François Tempé 1

2. Abbreviations  ASM : available solvency margin  Dir. : (EU) directive  EU : European Union  HK : hybrid capital  IAIS: International Association of Insurance Supervisors  ICPs: Insurance Core Principles laid down by the IAIS  L : Life, Life directive (depending on the context)  min(ASM, RSM) : the lesser of ASM and RSM  NL : Non life, Non life directive (depending on the context)  RSM : required solvency margin  SD : subordinated debt  SL : subordinated loan  S1 : Solvency I (current EU regulation on insurance)  S2 : Solvency II (future EU regulation on insurance, stemming from Dir.2009/138) 2 Rules on own funds

3. Summary Introduction 1. S1 rules for ASM 2. Some imperfections of ASM rules in S1 3. A brief overview of S2 rules on own funds 3 Presentation refers to the latest consolidated versions of all mentioned Directives, in particular Dir. 2002/83 (ultimately amended by Dir.2008/19) and Dir.1973/239 (ultimately amended by Dir. 2006/101). Page references, where provided, are those of the pdf file of consolidated versions, available at http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CONSLEG:2002L0083:20080320:EN:PDF http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CONSLEG:1973L0239:20070101:EN:PD http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CONSLEG:2002L0083:20080320:EN:PDF http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CONSLEG:1973L0239:20070101:EN:PD Reference to S2 directive: Dir.2009/138 25.11.20009, http://eur-le.g.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2009:335:0001:0155:EN:PDF http://eur-le.g.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2009:335:0001:0155:EN:PDF Rules on own funds

4. Introduction  IAIS ICP 17.11 states that criteria for admitting own funds should consider their ability to absorb losses on both a going concern and a wind-up basis. ICP 17.10.12 to 20 also note that some assets (such as intangibles), which may not be fully realisable, should be treated accordingly.  S1 requirements are only partly consistent with ICP 17.11. S2 regulation achieves greater consistency with IAIS ICPs.  S1 rules on own funds (ASM) admitted to cover capital requirements (RSM) are laid down in NL Art.16 (pp.17-21) and in L. art.27 (pp.41-45). Apart from a few items, L and NL rules on ASM are by and large identical. 4 Rules on own funds

5. Summary 1.S1 rules for ASM  Definition of ASM ≈ assets minus liabilities  Other balance sheet elements fully admitted  Balance sheet elements partly admitted  Off-balance sheet elements 5 Rules on own funds

6.  Definition of ASM: = assets minus liabilities (NL art.16.2; L.art.27.2)  With the following refinements:  Only half of the unpaid share capital is retained, this up to 50% of min(RSM, ASM), only on authorization by Supervisor, and only if at least 25% of share capital has been paid up (NL art.16.4.a; L.art.27.4.d) ;  For mutuals insurers, member’s accounts may be retained provided that paiements to member are subordinated to the insurer complying with RSM, or are subordinated to other debts if the insurer goes into liquidation (NL art.16.2.a p.17; L. art.27.2.a).  Intangible items are deducted (NL art.16.2.a; L. art.27.2.a). 6 Rules on own funds S1 rules for ASM

7.  Definition of ASM: = assets minus liabilities (cont.)  Own shares held by the insurer are deducted (NL art.16.2 p.18, L.art.27.1)  Participations in insurers or in banks are deducted, unless Group / Conglomerate solvency requirements are applied (NL. art.16.2 pp.18-19) (see dedicated presentation) ;  With the same waiver, subordinated loans granted to insurers or banks in which the insurer holds a participation, are also deducted (NL. art.16.2.b p.19) 7 Rules on own funds  ASM: balance sheet elements, that are not own funds, fully admitted  For Life insurers: profit reserves that may be used to cover any future losses and that have not yet been made available for distribution to PHs.

8.  ASM: balance sheet elements, that are not own funds, partly admitted  « Hybrid » and subordinated instruments, up to 50% of min(ASM,RSM), subject to the following conditions (NL art.16.3) :  Only paid-up funds are considered;  For instruments with a fixed maturity, the original maturity must be at least 5 years. These instruments are admitted up to 25% of min(ASM,RSM).  Early repayments are subject to the Supervisor’s authorization (NL. art. 3.a.ii & iii, art.3.b.i)  Any modification to the loan agreement is subject to the Supervisor’s authorization (NL. art. 3.a.v) 8 Rules on own funds

9.  ASM: off-balance sheet elements  These elements are admitted only on authorization by Supervisor (NL art.16.4, L. art.27.4)  Fully admitted: Hidden reserves arising out of the valuation of assets (NL art.16.4.c, L.art.27.4.c) ;  Partly admitted: For Non-life mutual insurers, half of any call for supplementary premium the Mutual can make against its Members. These supplementary calls may be admitted up to 50% of min(ASM,RSM). Supervisor should establish guidelines detailing conditions for these members calls to be admitted in ASM (NL art.16.4.b). 9 Rules on own funds

10. Summary 2.Some imperfecions of ASM rules in S1  Undated vs dated subordinated debt  Simple subordination vs double subordination  Capital elements which can absorb losses in the case of winding-up, and on a going-concern basis 10 Rules on own funds

11. Undated vs dated subordinated debt 11 Rules on own funds S1 is too simplistic. For instance, some undated loan may be practically equivalent to dated loan, when the undated loan provides for a significant step-up in interest at some date (e.g. 5 years after issuance). However, S1 does not differentiate between two such SLs: 1 year 3 years 5 years 7 years 9 years Debt interest rate: = benchmark rate, plus 1,5% (3,5%) before (after) 5 years benchmark rate (e.g. Euribor rate)

12. 12 Rules on own funds Some SLs stipulate a clause of double subordination: not only is the capital / principal of the loan subordinated, but interest also is, as well as any other debt arising from the contract —e.g. arising from a penalty clause. S1 makes no difference between simple and double subordination. Example. On 01.07.2008 an insurer takes a SL of 1.000. Annual interest on the loan is 9% and is payable every year. The loan should be reimbursed on 30.06.2011. It is also stipulated that any delay in payment will give rise to a further 0.5% monthly interest as penalty. Interest is compounded every year. Penalty is not compounded. Simple vs double subordination

13. 13 Rules on own funds On 30.06.2010 the insurer does not pay the annual interest. On 30.06.2011 it neither pays the interest nor does it reimburse the capital. On 01.03.2012, the insurer goes into liquidation. Accordingly, on 01.03.2012, the following is due: -principal, plus interest from 01.07.2009 to 29.02.2012: = 1000*1.09*1.09*(1+0.09*8/12) ≈ 1259.4 -penalty on interest due from 30.06.2010 to 30.06.2011: = 90*0.5%*12 = 5.4 -penalty on interest and capital due from 01.07. 2011: = 1000*1.09*1.09*0.5%*8 ≈ 47.5 Total debt : ≈ 1.000 + 312 In the event of “double subordination clause”, not only 1.000 is SD, but 312 also is. Simple vs double subordination (cont.)

14. 14 Rules on own funds Some more “absorbing” characteristics of some SD — “hybrid” capital— are not considered by S1. e.g. : subordinated funding which stipulates that - interests shall not be paid, - or the funding itself will not be repaid but instead will be converted into equity, if insurer’s ASM fall below a given level. For instance, a loan may stipulate that if ASM falls below RSM (or below twice the RSM, etc), then the amount of loan that is necessary to reconstitute ASM up to RSM (or up to 2*RSM, etc) is written down / is converted into equity. Although such loan is more absorbent than “ordinary” SD, S1 does not give it greater consideration. Loss-absorption on a going-concern basis

15. 15 Rules on own funds Example of hybrid capital that absorbs losses not only on liquidation but also on a going concern: RSM = 100 OF = 130 + HK = 80 31.12.2010 RSM = 120 OF = 70 + HK = 80 OF = 120 SD = 30 31.12.2011 15.01.2012 +

16. Page n°16 Example 2. S2 regulation. a) Distinction between 2 types of OF: i) basic OF: excess of assets over liabilities + SD ii) ancillary OF: -unpaid share capital; -letters of credit and guarantees; -any other commitment received by the insurer, e.g. mutuals’ claims against its members (“contingent” capital). Ref.: Dir. 2009/138, art. 87 to 98. Structure of capital resources for solvency purposes

17. Page n°17 Example 2. S2 regulation. b) Characteristics of OF (simplified) i) the item can absorb losses on a going-concern basis as well as in the case of winding-up ii) in the case of winding up, the whole item is subordinated iii) no incentives to redeem the nominal sum iv) no mandatory fixed charges Structure of capital resources for solvency purposes

18. Page n°18 Example 2. S2 regulation. c) Definition of the 3 tiers of OF Characteristicsi)ii)iii)iv) Tier Basic OF xxxx 1 xxx 2 Ancillary OF xxxx 2 other OF3 Structure of capital resources for solvency purposes

19. Page n°19 Example 2. S2 regulation (following) d) Eligibility and limits applicable to the 3 tiers The tiers are defined according their ability to absorb losses (cf. previous slide). Whence two keys ideas: i) The more absorbent a tier is, the more eligible it is to cover OF requirements; ii) Limits are stricter for MCR than for SCR. Thus: T3 is not allowed to cover the MCR T2 + T3 0,33*SCR) T2 0,5*MCR) Structure of capital resources for solvency purposes

20. 20 SCR 180 MCR 100 T2 T3 T1 T1 > 0,5*MCR 2*T1 > T2 + T3 S2 example: minimums of T1

21. 21 S2 example: maximums of T3 SCR 180 MCR 100 T2 T3 T1 Coverage of MCR T3 < 0,5 * (T1 + T2)

22. Diqqәtinizә görә minnәtdarιq Suallar var? Contacts: elie.sibony@acp.banque-france.fr elie.sibony@acp.banque-france.fr francois.tempe@acp.banque-france.fr 22 Rules on own funds