[pic] | COMMISSION OF THE EUROPEAN COMMUNITIES |

Brussels, 10.7.2007

SEC(2007) 871

COMMISSION STAFF WORKING DOCUMENT Accompanying document to the

Proposal for a DIRECTIVE OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL concerning life assurance on the taking-up and pursuit of the business of Insurance and Reinsurance SOLVENCY II IMPACT ASSESSMENT REPORT

{COM(2007) 361 final}{SEC(2007) 870}

1 PROCEDURAL ISSUES AND CONSULTATION OF INTERESTED PARTIES 4

1.1 Solvency II - Phase I 5

1.2 Solvency II - Phase 2 6

1.3 Involvement of CEIOPS 7

1.4 Solvency Expert Working Group 7

1.5 Other public consultation 8

1.6 Inter-Services Steering Group 8

2. PROBLEM DEFINITION 8

2.1 Grounds for regulation and supervision of insurance 8

2.2 The existing regulatory framework 9

2.3 Weaknesses of the current EU regime 9

2.4 Is action necessary at EU level? 14

3 OBJECTIVES OF THE SOLVENCY II PROJECT 14

3.1 General Objectives 15

3.2 Specific Objectives 15

3.3 Operational Objectives 16

4 POLICY OPTIONS, IMPACT ANALYSIS AND COMPARISON 18

4.1 Status quo versus change? (Annex B.1) 18

4.2 What legislative approach should be taken? (Annex B.2) 19

4.3 Consistency of prudential supervision of the insurance and banking sector (Annex B.3) 20

4.4 Group supervision (Annex B.4) 22

4.5 Small and medium sized undertakings (Annex B.5) 24

4.6 Calculation of technical provisions for prudential and accounting purposes Annex B.6) 26

4.7 Calculation of capital requirements (Annex B.7) 27

4.8 Methods for the calculation of technical provisions (Annex B.8) 29

4.9 Calibration of the Solvency Capital Requirement (SCR) (Annex B.9) 31

4.10 Choice of a risk measure for solvency purposes (VaR vs. TailVaR) (Annex B.10) 34

4.11 Design of the SCR standard formula (Annex B.11) 36

4.12 Calculation of the Minimum Capital Requirement (MCR) (Annex B.12) 37

4.13 Investment rules (Annex B.13) 39

5 OVERALL EXPECTED IMPACT OF SOLVENCY II 41

5.1 Retained approach for Solvency II: an economic risk based approach 41

5.2 Benefits for stakeholders 42

5.3 Potential short-term side-effects 43

5.4 Administrative costs 49

5.5 Dangers of not following an economic risk based approach 51

6 MONITORING AND EVALUATION 52

6.1 Next steps and development of implementing measures 52

6.2 Monitoring and evaluation planning 54

7 OVERVIEW OF ANALYTICAL WORK CONDUCTED 54

7.1 KPMG Report (Annex C.1a-b) 54

7.2 Sharma Report (Annex C.2) 54

7.3 PFS Report (Annex C.3) 55

7.4 QIS1 Report (Annex C.4) 55

7.5 QIS2 Report (Annex C.5) 55

7.6 DG ECFIN Report (Annex C.6) 56

7.7 ECB Report (Annex C.7) 56

7.8 Industry Reports (Annexes C.8a-e) 57

7.9 FIN-USE Report (Annex C.9) 58

7.10 CEIOPS Report (Annex C.10) 58

7.11 Commission questionnaire (Annex C.11a-b) 59

7.12 Company interviews (Annex C.12) 59

8 CHANGES MADE IN RESPONSE TO THE IMPACT ASSESSMENT BOARD OPINION 60

Annex A.1 – Solvency II Problem Tree

Annex A.2 – Solvency II Objectives

Annex A.3 – Lamfalussy Process

Annex A.4 – Solvency II Outline

Annex A.5 – Administrative costs

SOLVENCY II - IMPACT ASSESSMENT REPORT

This report commits only DG MARKT's Insurance and Pensions Unit that has prepared it. It is to serve as basis for comment and it does not prejudge the final form of any decision to be taken by the Commission.

Financial markets are pivotal for the functioning of modern economies. The more integrated they are, the more efficient the allocation of economic resources and long run economic performance will be. Completing the single market in financial services is thus a crucial part of the Lisbon economic reform process; and essential for the EU’s global competitiveness.

European financial market integration has been driven forward by the Financial Services Action Plan 1999-2005 (FSAP). Its central philosophy has proved sound: financial industry’s performance has improved; there is higher liquidity, increased competition, sound profitability and stronger financial stability despite much external turbulence. With progressive implementation of FSAP measures in the coming years, these benefits will only increase. But efforts have to continue.

The Solvency II project is one of the key outstanding items from the FSAP. The Solvency II project aims to overhaul prudential regulation and deepen integration of the EU insurance market. The project is closely linked with international developments in accounting, supervision and actuarial science and will take account of the developments in the banking area under Basel II.

Prudential regulation plays an important role in shaping the environment in which insurers operate. However, the regulatory environment is also shaped by European and national legislation in other areas including contract law, competition and taxation. This impact assessment report focuses solely on the impact of changes in the prudential regulatory environment.

PROCEDURAL ISSUES AND CONSULTATION OF INTERESTED PARTIES

The need to review EU insurance solvency rules was acknowledged in the third generation Insurance Directives[1] adopted in the 1990's. The Directives required the Commission to conduct a review of the solvency requirements. The Müller Report[2], prepared by EU insurance supervisors in 1997 for the Commission, noted several weaknesses in the EU regime and made some concrete recommendations for change, including increasing the level of the minimum guarantee fund. It also recognised that the relatively low level of the required solvency margin meant that an earlier intervention point was needed.

Following this review, a limited but expedited reform[3] was agreed by the European Parliament and the Council in 2002 – Solvency I – which raised the minimum guarantee fund as recommended. Solvency I also gave increased powers to supervisors to intervene at an earlier stage if deemed necessary to protect policyholder interests, even if the undertaking remained in compliance with the required solvency margin.

However, it became clear during the Solvency I process that a more fundamental and wider-ranging review of the overall financial position of an insurance undertaking was required. Subsequently, this review has become known as Solvency II.

Work on the Solvency II project has been greatly assisted by and has made use of the new Lamfalussy financial services committee architecture which was extended to insurance in 2003 (See Annex A.3 – Lamfalussy process). In particular, the new European Insurance and Occupational Pensions Committee (EIOPC) and the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS), along with their predecessor organisations the Insurance Committee and the EU Insurance Supervisors' Conference, have been extensively consulted throughout the project.

1.1. Solvency II - Phase I

Given the significance of the Solvency II project, it was decided that the work should be split into two phases. The work to be conducted in the first phase included:

- an analysis of the current EU regime, and supplementary Member State rules;

- a comparative analysis of insurance solvency regimes operated in other jurisdictions;

- an analysis of international developments in accounting, actuarial science and insurance supervision as well as prudential rules applied in banking;

- an analysis of the use being made of internal models by insurance and reinsurance undertakings to manage their business; and

- an analysis of a number of specific issues including technical provisions, asset-liability management, reinsurance and insurance groups.

The analysis included commissioning two external reports both of which were published in 2002. The KPMG Report (See Annex C.1a-b) looked at the methodologies used to assess the overall financial position of an insurance undertaking from the perspective of prudential supervision. The Sharma Report (See Annex C.2), a study conducted by the EU Insurance Supervisors' Conference, looked at the practical lessons that could be learned from EU supervisors' past experience as well as analysis of emerging trends in the risks faced by insurance undertakings (See Section 7 of this report for a brief summary of these reports and their findings). In addition, to these external reports, Commission Services also produced a number of working papers that were discussed with Member States and other stakeholders[4].

This analysis was used to determine whether action at EU level was necessary and, if so, what legislative procedure should be followed. Furthermore, this work enabled analysis to be conducted of the advantages and disadvantages of the various high level options relating to the overall design of the new solvency regime.

1.2. Solvency II - Phase 2

Following the completion of the first phase and the comparison of the various options for the overall design of the new solvency system, the key policy principles underpinning the new solvency system were agreed upon in consultation with stakeholders.

These principles were published by the Commission Services, following consultation with the predecessor of EIOPC, the Insurance Committee, in a Framework for Consultation[5] published in July 2004. In addition to the Framework for Consultation, three waves of Calls for Advice[6] were issued to CEIOPS, regarding different aspects of the new solvency system.

The Calls for Advice included a request for the testing of the quantitative impact of different detailed options by CEIOPS. In line with this request, CEIOPS carried out a preparatory field study ( PFS – See Annex C.3) in 2005; a first Quantitative Impact Study ( QIS1 – See Annex C.4) in 2005; and a second Quantitative Impact Study ( QIS 2 – See Annex C.5) in 2006. The PFS , QIS1 and QIS2 tested methods regarding the calculation of technical provisions and capital requirements.

In parallel, a number of assessments were prepared of the likely impact of the introduction of the new solvency system on:

- The macro-economy, by the Commission's Directorate General of Economic and Financial Affairs ( DG ECFIN Report – See Annex C.6);

- Financial stability, by the European Central Bank ( ECB Report – See Annex C.7);

- Insurance products and markets, by the CEA, AISAM & ACME[7] ( Industry Reports - See Annex C.8a-e);

- Consumers, by FIN-USE[8] ( FIN-USE Report - See Annex C.9); and

- Supervisory authorities, by CEIOPS ( CEIOPS Report – See Annex C.10).

This analysis was used to determine which options should be chosen for the new solvency system (See Section 7 of this report for a brief summary of these reports and their findings).

1.3. Involvement of CEIOPS

CEIOPS[9] is a key partner and source of technical expertise for the Solvency II project. Its contribution to the project has been substantial, and its involvement will also be needed later on in the process.

1.3.1. CEIOPS' Solvency II working groups

CEIOPS set up a number of working groups consisting of experts from the national supervisory authorities to prepare its technical advice (Pillar 1, initially split between life and non-life; Pillar 2, Pillar 3, and Group/Cross-sectoral issues). In addition, one permanent CEIOPS committee, the Financial Stability Committee, has been involved in the Solvency II project through its organisation of the Quantitative Impact Studies ( PFS , QIS1 and QIS2 ). Outside parties, experts and stakeholders have been invited to contribute their expertise and insight into the work of the various working groups.

CEIOPS has also set up the Task Force on COnvergence and iMPact ASSessment (COMPASS) looking at the impact of Solvency II on supervisory authorities, including the net administrative costs associated with the introduction of Solvency II.

1.3.2. CEIOPS' consultation processes

Consultation and transparency are essential elements of the Lamfalussy process. The creation of a robust regulatory framework and the adoption of effective and convergent supervisory practices rely both on a clear and complete knowledge of the EU insurance market, and on the development of common widely accepted approaches towards insurance supervision.

In this regard, CEIOPS has committed to work in an open and transparent way. Before sending its advice to the Commission, CEIOPS publicly consults on its draft advice. This approach is in line with CEIOPS' Public Statement of Consultation Practices published in February 2005[10].

In addition to publicly consulting on its draft advice, CEIOPS also

- consults informally at working group level with outside experts, and other stakeholders, throughout the development of its advice to the Commission;

- holds regular public hearings to allow stakeholders to express their views;

- reports to a Consultative Panel composed of some 16 experts, who either work in the insurance industry or work for organisations representing end-users of insurance products.

1.4. Solvency Expert Working Group

The Solvency Expert Working Group is a Commission working group that was set up originally as a sub-committee of the Insurance Committee. The members of the working group are Member States' solvency regulation experts drawn from their competent authorities and representatives from the relevant responsible ministries (mainly Ministries of Finance).

From the beginning of the project the Solvency Expert Working Group has met 3 to 5 times a year. In 2006, the Solvency Expert Working Group met 8 times, and has already met 3 times in 2007. Stakeholders have been asked to present their views on the project at many of these Solvency Expert Working Group meetings.

1.5. Other public consultation

In June 2006, DG MARKT organised a public hearing which drew 191 participants. In addition, the Commission Services ran an online public questionnaire published on "Your Voice in Europe" which attracted over 147 responses ( Commission Questionnaire - See Annex C.11a-b). DG MARKT also sent a detailed questionnaire to 58 undertakings from across Europe, and this was followed up by face-to-face interviews with 17 of those undertakings ( Company interviews - See Annex C.12).

In addition, throughout the project the Commission Services have maintained close contact with other key stakeholders and have followed international developments, including the work of the International Association of Insurance Supervisors[11] (IAIS), the International Accounting Standards Board[12] (IASB) and the International Association of Actuaries/Groupe Consultatif[13] (IAA/GC).

1.6. Inter-Services Steering Group

An Inter-Services Steering Group was set up to follow progress and feed in views from different services of the Commission. The group had representation from Directorate Generals SANCO, ECFIN, EMPL, JLS, ENTR, the Joint Research Centre as well as the Secretariat General. The Steering Group met three times, in December 2005, July 2006 and February 2007. The Insurance and Pensions Unit also ran an intra-DG MARKT focus group to discuss the Solvency II project.

2. PROBLEM DEFINITION

2.1. Grounds for regulation and supervision of insurance

The economic and social importance of insurance is such that intervention by public authorities, in the form of prudential supervision, is generally accepted to be necessary. Not only do insurers provide protection against future events that may result in a loss, but they also channel household savings into the financial markets, and into the real economy.

The reasons generally cited for the necessity of public intervention are:

- Insurers collect premiums up-front, but are only obliged to pay if an event occurs at some future date (inverted production cycle);

- Policyholders understand less than the insurer about the latter's ability to fulfil the terms of an insurance contract (solvency);

- Policyholders understand less than insurers about the risks underlying an insurance contract (conduct of business);

- The interests of policyholders and insurers are not the same (agency conflicts).

Consequently, intervention by public authorities has tended to focus on introducing measures that seek to guarantee the solvency of undertakings, or minimise the disruption and loss caused by insolvency.

In addition, in order to address imbalances in the knowledge and understanding of contracting parties, historically also the form and content of insurance contracts have tended to be regulated as well as their pricing. Indeed, "form and rates" type restrictions were only abolished in the EU in the early 1990s. Reinsurance, however, as it is conducted between two knowledgeable parties, has tended to be subject to less public intervention.

2.2. The existing regulatory framework

The rationale for EU insurance legislation is to facilitate the development of a Single Market in insurance services, whilst at the same time securing an adequate level of consumer protection. In this respect, the European Court of Justice concluded in 1986[14] that Member States could demand compliance with their own rules if the existing rules regarding the calculation of technical provisions and the valuation, diversification, matching and localisation rules of assets backing technical provisions were not sufficiently harmonised – that is to say – unless a certain common minimum level of consumer protection was agreed at EU level.

The development of the necessary legislative framework began in the 1970s with the first generation Insurance Directives[15], but was only completed in the early 1990s with the third generation Insurance Directives. The third generation Insurance Directives established an “EU passport” (single licence) for insurers based on the concept of minimum harmonisation and mutual recognition. The main focus of the Directives is setting out rules for establishing prudent technical provisions; setting out rules relating to assets backing technical provisions; and setting out rules for a required solvency margin, to be calculated using simple, harmonised fixed ratios.

2.3. Weaknesses of the current EU regime

Although Solvency I updated the EU regime in 2002, a number of structural weaknesses remain. In particular, the regime is not risk sensitive; it has not ensured the removal of all restrictions preventing the proper functioning of the single market; it does not properly deal with group supervision; and it has been superseded by industry, international and cross-sectoral developments (See Annex A.1 – Solvency II Problem Tree).

2.3.1. Lack of risk sensitivity

One of the key problems with the current EU regime is its lack of risk-sensitivity. A number of key risks, including market, credit and operational risk are either not captured at all in the required solvency margin or are not properly taken into account. The current EU regime is not forward looking. The required solvency margin calculation is based on past data. Member States have the option to value assets at their historic cost and to apply a discount rate to life liabilities consistent with the condition of the government bond market at the time the contract was concluded.

The current required solvency margin also gives little or no credit for risk mitigation tools such as reinsurance, securitisation and derivatives and does not give EU insurers credit for diversification effects across lines of business or between legal entities. Furthermore, the current EU regime contains many quantitative requirements, but has very few requirements focussing on qualitative risk factors, such as organisation of risk management and quality of governance, and does not require supervisors to conduct regular reviews of these qualitative aspects.

This lack of risk sensitivity has the following consequences:

- It does not incentivise insurers to manage their risks adequately, or to improve and invest in risk management;

- It does not ensure accurate and timely intervention by supervisors;

- It does not facilitate optimal allocation of capital.

As a result, the current EU regime does not offer an optimum level of policyholder protection. The Sharma Report , which analysed recent insurance failures and 'near misses', illustrated how policyholder protection was undermined by the current EU regime as a result of its lack of risk sensitivity.

One of the main conclusions of the report is that the primary causes of failures and 'near-misses' between 1996 and 2001 were poor management and inappropriate risk decisions rather than inadequate capitalisation per se. Furthermore, the analysis showed that the current required solvency margin did not act as a useful early warning indicator that the insurer was getting into financial difficulties.

The value of detecting and addressing the root causes of insurance failures can be substantial if, as a result, the causal chain precipitating insolvency is interrupted and its adverse effects contained. For example, it was estimated that only 40% of gross insurance liabilities of £12.5 billion resulting from insolvencies that occurred in the UK mostly in the 1990’s would eventually be recovered[16].

Answers provided by Member States to Commission Services in response to a Questionnaire on Insurance Guarantee Schemes[17] conducted in 2003, suggest that between 1999 and 2003 annual losses throughout the EU arising from insolvencies in the non-life sector alone, were in access of €500 million.

CEIOPS’ survey on failed insurers and ‘near-misses’ in 2005[18] confirmed the findings of the Sharma Report - i.e. that the current solvency margin does not provide sufficient early warning for an intervention to be launched and that bad management decisions lay behind many of the problems. In more than 75% of the cases examined by CEIOPS, the reported solvency ratio up to one year before failure was more than 100%, and in 20% of the cases, the reported ratio was over 200%.

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Source: CEIOPS

As well as undermining policyholder protection, the lack of risk sensitivity of the current regime also impacts the international competitiveness of EU insurers and reinsurers, because it does not give appropriate credit for the use of risk mitigation techniques and diversification effects and does not provide for optimal allocation of capital.

Given the importance of insurers as institutional investors in European capital markets, the lack of risk sensitivity of the required solvency margin not only results in a sub-optimal allocation of capital between lines of business and across the industry, but also throughout the economy as a whole.

2.3.2. Restrictions on the proper functioning of the Single Market

The present EU framework sets out minimum standards that can be supplemented by additional rules at national level. These additional rules distort and undermine the proper functioning of the Single Market in insurance. This increases costs for EU insurers (and policyholders), hinders competition within the EU and undermines the international competitiveness of EU insurers and reinsurers.

The lack of harmonisation across the EU has increased over the years as Member States have updated their rules to bring them into line with developments in financial markets, actuarial science, and risk management techniques and technology. The current EU regime has been left behind, and a gap has emerged between regulatory requirements and industry best practice.

Most Member States operate an 'EU-minimum plus' regime whereby insurers are subject to more stringent requirements than those set out in the Insurance Directives. There are also continuing significant differences in the way in which supervision is conducted, which further undermines the creation of a level playing field and the integration of the EU insurance market.

The key underlying difference between the approaches adopted by Member States when supplementing the rules laid down in the Insurance Directives relates to the importance attached to technical provisions and capital requirements. Other areas where different approaches are applied include the eligibility and valuation of assets as well as the quantitative limits applied to investments.

The KPMG Report includes comparative analysis of rules and methods applied in different Member States including the approaches adopted towards the valuation of assets, the calculation of technical provisions and the calculation of solvency requirements as well as the differing investment rules applied (See example table below, taken from the KPMG report related to differences in the statistical methods used to calculate technical provisions).

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The KPMG Report also analyses and looks at the potential impact of changes in future international accounting and regulatory standards. Since the KPMG Report was published in 2002, further changes have taken place. For example, in the UK an entirely new prudential regime for insurers (Individual Capital Adequacy Standards) has been introduced.

2.3.3. Sub-optimal arrangements for the supervision of groups

It is widely accepted that an insurers' capacity to operate across the EU is often most readily achieved through a group structure, partially for fiscal reasons and partially in order to be closer to their customers. The current approach of 'supplementary' supervision of groups, as set out in the Insurance Groups Directive[19], is based on a model of loose, voluntary co-operation between supervisory authorities, where the main focus remains on the subsidiaries of the group.

The 'solo plus' supervisory view of groups has increasingly become detached from the reality of how groups are actually structured and organised. The organisation of groups has become increasingly centralised as enterprise-wide risk management systems have been introduced and key functions such as treasury, risk management, modelling and investment management have been consolidated.

The lack of real supervisory convergence and coordination, as well as the differing rules applied by Member States, impose an unwarranted administrative burden on groups, arising from unnecessary duplication of effort, which undermines the development of a competitive and well-functioning single insurance market (See Industry Reports - Annex C.8e). The gap between the way groups are managed and supervised not only increases costs for insurance groups but also increases the danger that some key group-wide risks may be overlooked.

2.3.4. Lack of international and cross-sectoral convergence

The IAIS has produced a number of high level papers in recent years regarding solvency standards for insurers, including a paper setting out a new Framework for insurance supervision, a Cornerstones paper and a Structure paper[20].

These papers set out the principles that a modern insurance solvency regime should meet as well as the key elements a solvency regime should have. In addition to the work being done on solvency standards, the IAIS is also closely following the insurance contracts project of the IASB and has produced its own papers on the valuation of insurance liabilities. International assessments of a jurisdiction's regulatory framework conducted by organisations such as the International Monetary Fund (IMF) use IAIS standards as a benchmark.

The work of the IAIS on the development of new solvency standards and on the valuation of technical provisions is moving towards an economic risk based approach with respect to the assessment of insurance solvency and a market consistent approach with respect to the valuation of liabilities. These approaches are radically different from the philosophy underlying the current EU regime.

In the banking field, steps have recently been taken to introduce a more risk sensitive capital regime via the international Basel II[21] agreement and the European Capital Requirements Directive[22] (CRD).

There are an increasing number of insurers and bancassurance groups operating internationally. In addition, insurers these days often find themselves competing with banks offering similar products in the same market. A lack of international and cross-sectoral convergence risks undermining the international competitiveness of insurers and the competitiveness of insurers vis-à-vis banks in those markets where they compete against each other directly. Lack of cross-sectoral consistency also increases the possibility of regulatory arbitrage.

2.4. Is action necessary at EU level?

The lack of risk sensitivity of the current EU regime does not provide incentives for insurers to manage their risks properly, or improve and invest in risk management and does not facilitate accurate and timely intervention by supervisors nor optimal allocation of capital.

In order to address the weaknesses of the current EU regime, Member States have introduced additional rules that have resulted in widely diverging regulatory requirements and supervisory practices throughout the EU. The resulting lack of harmonisation undermines the proper functioning of the Single Market and imposes significant costs on insurance groups operating in more than one Member State.

Although in theory it is possible that Member States could introduce similar regulatory regimes to rectify problems in the current system, and that supervisory authorities could better co-ordinate their supervisory activities, thus removing the obstacles to the proper functioning of the Single Market, there is little evidence of this occurring in practice.

Indeed, current experience would suggest that the opposite is the case. Action is necessary to bring about change, and this action needs to be taken at EU level in order to ensure that a more harmonised framework is put in place that will deepen the integration of the EU insurance market, enhance policyholder protection and improve the international competitiveness of EU insurers and reinsurers.

3. OBJECTIVES OF THE SOLVENCY II PROJECT

The Solvency II project has three sets of objectives; general, specific and operational objectives (See Annex A.2 – Solvency II Objectives).

- General Objectives are the overall goals of the Solvency II project.

- Specific Objectives are the immediate goals of the Solvency II project – the targets that first need to be reached in order for the General Objectives to be met.

- Operational Objectives are deliverables the Solvency II project should produce. These generally will be directly verifiable.

The four general objectives of the Solvency II project are to deepen the integration of the EU insurance market, enhance the protection of policyholders and beneficiairies, improve the competitiveness of EU insurers and reinsurers and promote better regulation.

The primary objective of the Solvency II project is to deepen integration of the EU insurance market in line with the legal base underpinning Community legislation in this area (Articles 47(2) and 55 of the Treaty). However, in order to achieve this objective it is necessary to agree a common minimum level of consumer protection for policyholders and beneficiaries in line with the 1986 decision of the European Court of Justice[23].

In addition to these two objectives, the Solvency II project also forms part of the Financial Services Action Plan which is designed to drive forward market integration in order to improve long run economic performance. Completing the single market in financial services is thus a crucial part of the Lisbon economic reform process; and essential for the EU’s global competitiveness.

Consequently, when assessing the merits of the various policy options and approaches set out in this report regarding the design of Solvency II, the aim is to deliver a system that addresses the weaknesses of the current regime, in particular with respect to removing obstacles to the proper functioning of the single market, whilst achieving an appropriate balance between the objectives of enhancing the protection of policyholders and beneficiaries and improving the international competitiveness of EU insurers and reinsurers.

3.1. General Objectives

3.1.1. Deepen the integration of the EU insurance market

Legislative action has been taken over the last 35 years to facilitate the development of a Single Market in insurance services. Nevertheless, obstacles remain to the full integration of the EU insurance market. One of the main reasons for this is the lack of harmonisation of Member States' rules and a lack of convergence of supervisory practices. Solvency II should deepen the integration of the EU insurance market by removing these obstacles.

3.1.2. Enhance the protection of policyholders and beneficiaries

Policyholder protection is the primary reason for prudential supervision, and agreeing what level of protection policyholders should be afforded has proved to be one of the major stumbling blocks in creating a Single Market in insurance. The lack of risk sensitivity of the current EU regime undermines policyholder protection. Solvency II should enhance the protection of policyholders and beneficiaries.

3.1.3. Improve the international competitiveness of EU insurers and reinsurers

The current EU regime has been left behind by developments in financial markets, actuarial science, risk management technology and techniques, international supervisory and accounting standards. This imposes unnecessary costs on insurers and undermines their international competitiveness. Solvency II should improve the international competitiveness of EU insurers and reinsurers.

3.1.4. Promote Better Regulation

The current EU insurance regime is based on a complex web of Community legislation, diverging national implementations and differing supervisory practices. Solvency II should make full use of impact assessments and studies pre and post adoption, and should result in a more comprehensible, more easily accessible and more consistently applied regime across all Member States.

3.2. Specific Objectives

3.2.1. Improve the risk management of EU insurers and reinsurers

The current EU regime does not focus adequately on risk management and it does not provide incentives for EU insurers to measure and properly manage their risks. For example, insurers are not provided with incentives to consider the qualitative aspects that influence their risk-standing (e.g. managerial capacity, internal risk control and risk monitoring processes, etc). Solvency II should ensure that the new regime requires, and provides sufficient incentives for, insurers to improve their risk-management.

3.2.2. Advance supervisory convergence and co-operation

A number of insurance groups operate in several Member States and the cross-border provision of services has also increased. However, Member States have widely differing supervisory rules and practices. These differing rules and practices undermine the Single Market and increase costs for insurers operating in more than one Member State. Solvency II should advance supervisory convergence and co-operation.

3.2.3. Encourage cross-sectoral consistency

The lack of consistency between the current EU insurance regime and the regulation and supervision of other financial sectors undermines the competitiveness of EU insurers and reinsurers, increases the possibility of regulatory arbitrage and makes supervision of financial conglomerates less effective and efficient. Solvency II should encourage cross-sectoral consistency.

3.2.4. Provide for a better allocation of capital resources

The lack of risk sensitivity of the current regime distorts allocation of capital resources both between lines of business and across the industry as a whole. The lack of risk sensitivity also impacts on the investment strategies of EU insurers and reinsurers, which in turn has implications for EU capital markets and the wider economy. Solvency II should promote better allocation of capital resources.

3.2.5. Promote international convergence

The EU has the most open financial market in the world and is fully committed to the opening of global financial markets. The principles and standards currently being developed by the IASB and the IAIS are likely to supersede those underpinning the current EU insurance regime. Solvency II should be compatible with current and future international standards, and should further international convergence.

3.2.6. Increase transparency

The current lack of harmonisation of Member States' rules and the lack of convergence of supervisory practices, as well as the lack of risk sensitivity of the current EU regime, makes it difficult for prospective and existing stakeholders to properly understand and compare the financial position of insurers, and the risks they are subject to. Solvency II should increase transparency.

3.3. Operational Objectives

3.3.1. Codify and recast the existing Insurance Directives

As part of Solvency II, 13 existing insurance Directives (including Life, Non-life, Reinsurance, Insurance Groups and Winding-up Directives) will be codified and recast into one single text. The text of the existing Directives will be adapted and restructured to make it more accessible. The only substantive changes that will be made are those necessary for the introduction of the new solvency regime.

3.3.2. Harmonise the calculation of technical provisions

The current EU legislation does not provide for a sufficiently harmonised calculation of technical provisions across Member States. The calculation of technical provisions is one of the areas where differences between Member States are most marked. Solvency II should ensure that a harmonised approach to the calculation of technical provisions is adopted.

3.3.3. Introduce risk-sensitive harmonised solvency standards

The current solvency requirements are not risk sensitive. They do not provide adequate incentives to improve risk management, nor do they facilitate timely and proportionate intervention by supervisors. Solvency II should introduce more risk-sensitive harmonised solvency standards.

3.3.4. Introduce proportionate requirements for small undertakings

Small insurance undertakings play an important role in the economic environment and should not be subjected to unnecessary regulation. Solvency II should ensure that all quantitative and qualitative regulatory requirements imposed on insurers are proportionate to the nature, scale and complexity of the insurer and its operations.

3.3.5. Harmonise supervisory powers, methods and tools

Supervisors have diverging powers, practices and methods. The current EU insurance regime is supplemented by additional requirements in Member States. Solvency II should ensure that supervisors have the same powers, and that they apply methods and tools in a consistent manner.

3.3.6. Harmonise supervisory reporting

Supervisory reporting requirements vary widely across Member States. These differing requirements impose unnecessary costs on insurers operating in more than one Member State. Solvency II should harmonise and streamline supervisory reporting requirements.

3.3.7. Promote compatibility of prudential supervision of insurance and banking

The current EU insurance regime differs markedly from the new risk-sensitive banking regime introduced by the CRD. Solvency II should ensure that the regulatory and supervisory approaches adopted for insurance are compatible with those in the banking field.

3.3.8. Promote compatibility of valuation and reporting rules with the international accounting standards elaborated by the IASB

Solvency II should ensure that valuation rules, supervisory reporting and public disclosure requirements are compatible with the international accounting standards elaborated by the IASB. Solvency II should not result in all insurance undertakings being required to make full use of IAS/IFRS. Certain prudential valuation rules, reporting and disclosure rules may however be similar to IAS/IFRS rules.

3.3.9. Promote compatibility of the prudential regime for EU insurers with the work of the IAIS and the IAA

Solvency II should ensure that solvency standards applied to EU insurers and reinsurers are in line with the work of the IAIS and the IAA. In particular, Solvency II should ensure that the solvency standards applied to EU insurers and reinsurers are compatible with the IAIS Framework for supervision and Cornerstones for the formulation of regulatory financial requirements.

3.3.10. Ensure efficient supervision of insurance groups and financial conglomerates

Solvency II should ensure that supervisory tasks are appropriately split between the competent supervisors in order to ensure efficient supervision of insurance groups and financial conglomerates.

4. POLICY OPTIONS, IMPACT ANALYSIS AND COMPARISON

The Solvency II project has considered, analysed and compared a number of policy options. The policy options have been split into "high level" and "low level" policy options. The high level options were compared and analysed during Phase I. Analysis and comparison of the low level options and further detailed analysis of the impact of the direction chosen at the end of Phase I was conducted during Phase II.

High Level Policy Options

A number of high level options have been analysed and compared, including whether a change is needed, and if so, what legislative procedure should be followed. In addition, a number of key questions regarding the overall design were analysed. These included the extent to which lessons could be learned from Basel II and the CRD; how insurance groups should be supervised; how small and medium sized insurers should be treated; whether the calculation of technical provisions should be harmonised; and what approach should be taken with respect to the calculation of capital requirements. More detail on each high level option is provided below, together with a short summary setting out which option was taken and why. Detailed analysis and comparison of each option is presented in Annexes B.1-B.7.

4.1. Status quo versus change? (Annex B.1)

At the start of the Solvency II project, four possible courses of action were considered: stick with the Solvency I amendments; make specific targeted modifications to the Solvency I regime addressing only major deficiencies identified as part of the analysis; wait for the development of an international solvency solution by the IAIS before embarking on reform of the EU insurance acquis ; or build a new EU solvency system from scratch, rather than using Solvency I as a base or waiting for an international solvency solution to be developed.

These options can be summarised as and will be referred to in the rest of this report as follows:

- Option 1.1 : No change;

- Option 1.2 : Update the existing directives;

- Option 1.3 : Wait for international solvency solution;

- Option 1.4 : Develop new EU solvency system.

Significant weaknesses were already identified in 1997, and the limited reform in 2001 was only a stop-gap measure needed to improve policyholder protection whilst a more fundamental reform was undertaken.

The underlying structural problems of the current regime (See Section 2) are such that sticking with the current regime (Option 1.1) or making targeted amendments to the existing directives (Option 1.2) would not be sufficient to address the problems identified. In addition, significant developments in the banking sector (Basel II/Capital Requirements Directive) mean that maintaining cross-sectoral consistency would not be possible if only minor amendments were made.

Whilst waiting for an international solution would reduce the risk of the new EU regime diverging from future global standards (Option 1.3), it would mean that weaknesses in the current EU regime would remain unresolved in the medium to long term.

Consequently, Option 1.4 was chosen , as this option in comparison to the others most effectively and sustainably, meets the objectives of deepening the integration of the EU insurance market, enhancing policyholder protection, and improving the international competitiveness of EU insurers.

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4.2. What legislative approach should be taken? (Annex B.2)

The "Lamfalussy" process (See Annex A.3 – The Lamfalussy Process) is a new dynamic approach to the development of financial services regulation and supervision, designed to deliver more integrated and efficient regulatory and supervisory structures that fits in well with the general Better Regulation Agenda. The extent to which to utilise this approach in Solvency II, and in particular, the extent to which Solvency II should make use of implementing measures as the legislative tool to introduce the technical details of the new solvency system, is a question of key importance when deciding the legislative approach[24].

The extent to which a particular legislative project can be used to simplify and make EU legislation more accessible should also be considered. For Solvency II, the issue was whether or not to consolidate the existing insurance acquis which is spread across 13 Directives. In particular, the treatment of life and non-life insurance undertakings is dealt with in different Directives, as is the treatment of insurance groups and reinsurers.

The options regarding the legislative approach can be summarised as, and will be referred to in the rest of this report as:

- Option 2.1 : Update the existing directives with only level 1 legislation;

- Option 2.2 : Update the existing directives with level 1 legislation and level 2 implementing measures;

- Option 2.3 : Codify the existing direct insurance, reinsurance and groups directives and update with only level 1 legislation;

- Option 2.4 : Codify the existing direct insurance, reinsurance and groups directives and update with level 1 legislation and level 2 implementing measures.

Codifying the existing Directives and integrating the new principles in one single document would make European Law clearer and more accessible to all stakeholders. In addition, the use of level 1 and level 2 implementing measures, would make it easier to update legislation in the light of future market and technological developments as well as international developments in accounting and insurance regulation. Furthermore, using the full Lamfalussy architecture will result in a more harmonised treatment of insurers across Europe.

Consequently, Option 2.4 was chosen, as this option most effectively and sustainably contributes to the promotion of Better Regulation, cross-sectoral and international convergence, and the advancement of supervisory convergence and cooperation.

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4.3. Consistency of prudential supervision of the insurance and banking sector (Annex B.3)

The Capital Requirements Directive (CRD) for credit institutions and investment firms was adopted by the Council and the European Parliament in June 2006[25]. The Directive introduced an updated supervisory framework in the EU, reflecting new rules on capital standards for internationally active banks agreed at G-10 level by the Basel Committee on Banking Supervision. The Directive came into force on 1 January 2007 and applies to the majority of banks and investment firms operating in the EU.

Given that insurers and banks now compete in many markets offering similar products and that there are now a large number of Bancassurance groups operating in Europe, one of the key policy issues regarding the new solvency regime is the extent to which new capital rules for insurers should be aligned with that of other financial sectors, including banking.

The question of alignment of insurance and banking capital rules is also important because as a result of the growing linkages between the insurance and banking sectors (See ECB Report ), the insurance industry is increasingly being viewed as a potential source of vulnerability for financial stability.

A key feature of the new banking rules often referred to as Basel II, is the introduction of a three pillar structure. The first pillar relates to minimum capital requirements; the second pillar to supervisory review processes; and the third pillar to measures designed to foster market discipline (i.e. disclosure requirements)[26].

The options regarding the extent to which Solvency II should follow the same approach as the Basel Committee can be summarised as, and will be referred to in the rest of this report, as follows:

- Option 3.1 : Retain current quantitative supervisory approach;

- Option 3.2 : Adopt first and second Basel Pillars (quantitative and qualitative);

- Option 3.3 : Adopt all three Basel Pillars including market discipline;

- Option 3.4 : Adopt adjusted more harmonised Basel three pillar approach

The current insurance solvency regime is based on three different sets of quantitative rules. First, rules regarding the calculation of technical provisions. Second, rules regarding the types of assets that can be used to cover technical provisions. Third, rules regarding minimum capital requirements (often referred to as the required solvency margin).

The introduction of harmonised Pillar 2 requirements, similar to those under Basel II, in the new solvency regime would enhance policyholder protection through the introduction of qualitative risk management standards for insurers. They would also ensure more effective and efficient supervision resulting from a better understanding by supervisors of the risks run by insurers. In particular, the introduction of Pillar II requirements in the new solvency regime would enhance policyholder protection by ensuring more accurate and timely interventions by supervisors (See Sharma Report ). Furthermore, the requirement for insurers to perform their own risk and solvency assessment would improve risk and capital management and help align regulatory and industry practice[27].

The introduction of Pillar II requirements in the new solvency regime would, though, require increased supervisory resources (See CEIOPS Report ), especially if internal models are allowed to be used in the calculation of capital requirements and to perform the internal risk and capital assessment, as is the case in Basel II. In particular, new specialist staff will need to be recruited and existing staff will need to be re-trained.

The introduction of Pillar 3 requirements, similar to those under Basel II, in the new solvency regime would also enhance policyholder protection by providing incentives for insurers to maintain adequate financial resources. The introduction of disclosure requirements would also increase transparency and therefore confidence in the insurance sector as a whole, which should result in a reduction in the cost-of-capital of insurance undertakings (See Industry Reports – Annex C.8c).

However, in the short-term there is a risk that increased transparency could have some negative impacts. For example, some undisclosed information available to insurance undertakings (risk management, customer information, etc) may provide them with a competitive advantage. Hence requirements to disclose this information could in some circumstances have a negative short-term impact on profitability. Another potential short-term negative impact following the introduction of new disclosure requirements relates to publication of breaches of capital requirements, which could aggravate the situation of insurance undertakings in financial difficulties. New disclosure requirements will also increase the administrative burden on insurance undertakings (See Industry Reports - Annex C.8c).

Option 3.4 was retained, in line with the conclusions of the KPMG Report , as it more effectively meets the objectives of advancing supervisory convergence and cooperation and increasing transparency than option 3.3. Even though, as it goes further with respect to harmonisation than the CRD, Option 3.4 contributes less effectively than Option 3.3 to the objective of promoting compatibility of prudential supervision of insurance and banking.

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4.4. Group supervision (Annex B.4)

Under Solvency I the focus of supervision is on legal entities, although supplementary provisions are applied to solo entities forming part of an insurance group (the so-called "solo plus" approach).

There are a large number of insurance groups operating within the EU on a cross-border basis. The internal control and risk management systems of many of these groups are managed centrally and do not necessarily correspond to the legal structure of the group.

Consequently, under the current prudential regime the supervision of groups operating on a cross-border basis is rarely aligned to the way in which the group organises and manages itself. This is particularly true when it comes to capital management and the use of internal models, which are often designed and implemented centrally and take account of diversification effects across entities (See KPMG Report – Section 3).

This raises the question of what role solo and group supervisors should play in the supervision of legal entities within a group, particularly if internal models are allowed to be used under Solvency II (See Section 4.7).

The supervisory models discussed included: 1) retaining a "solo plus" approach to supervision, but with increased cooperation and coordination between European supervisory authorities; 2) entrust all the tasks involved in the prudential supervision of the different entities within a group to the group supervisor; or 3) reallocating responsibilities between solo and group supervisors, such that for example the solo supervisor is responsible for monitoring core aspects, whilst the group supervisor is responsible for monitoring capital allocation within the group.

The options regarding the supervisory arrangements of insurance groups can thus be summarised and will be referred to in the rest of this report as follows:

- Policy Option 4.1 : Retain current solo plus approach;

- Policy Option 4.2 : Assign responsibility for prudential supervision of a group to a single lead supervisor;

- Policy Option 4.3 : Re-allocate responsibilities of solo and group supervisors.

Option 4.1 is criticised by the European insurance industry, because it bears the brunt of the extra administrative costs arising from this supervisory approach: as there is no real group supervisor under Option 4.1, insurance groups do not have any clear contact point with whom to discuss their general strategy, they need to send the same information to several supervisors - in accordance with various reporting formats - and sometimes receive contradictory instructions from solo supervisors (See Industry Reports – Annex C.8e). Moreover, lack of coordination can be especially damaging with respect to the recognition of diversification effects across entities forming part of a group, as this would result in insurance groups being required to hold more own funds than necessary, which would hamper efficient capital allocation within the insurance sector and the EU economy as a whole, and would increase costs for insurers (i.e. cost of raising idle own funds).

On the other hand, Option 4.1 provides a lot of comfort to solo supervisors, who can monitor and enforce all requirements at the solo level and ensure strong policyholder protection. Therefore, as far as policyholders are concerned, option 4.1 is likely to have mixed indirect effects: on the one hand, it is very conservative and delivers prudent capital requirements; on the other hand, it increases costs for insurers and ultimately puts upward pressure on insurance premiums.

Option 4.2 is strongly supported by the EU insurance industry, as it assigns full responsibility for the supervision of a group to a single lead supervisor and addresses most of the pitfalls identified with Option 4.1. Option 4.2 however raises a number of significant practical concerns, especially for cross-border insurance groups: it implies that the lead supervisor is able to hire enough staff, with the appropriate language and technical skills, to carry out by himself the supervision of all entities forming part of a group; and it provides no incentive to develop a common European supervisory culture, which may seriously hamper harmonisation across the EU. At least in the medium term, lead supervisors would face serious practical difficulties to carry out the supervision of entities in another Member State and it cannot be excluded that the timeliness of supervisory action and policyholder protection would suffer from that change.

Option 4.3 aims at achieving an appropriate balance between options 4.1 and 4.2. Indeed, by appointing a lead supervisor who coordinates supervisory actions, it ensures information flows between all relevant supervisory authorities and delivers all the benefits of option 4.2 (i.e. reduced administrative costs, better capital allocation, increased competitiveness, and lower insurance prices). In addition, it dodges all practical problems raised by the second option, since tasks are efficiently shared between the solo and the lead supervisors, providing for optimal policyholder protection and promoting supervisory convergence.

Option 4.3 nevertheless has one possible negative implication. The recognition of diversification effects implies that well diversified entities, or those which are part of an insurance group will, in practice have lower capital requirements than single solo entities which are less well diversified. Although this is fully in line with the basic economic principles underpinning the proposal, and does not entail lower protection for policyholders, it may nevertheless act as a catalyst to the already existing trend of consolidation in the EU insurance market and increase already existing competitive pressures on small and medium-sized insurers.

Option 4.3 has been retained as the best option since it achieves a fair balance between the other two options. It most effectively and efficiently contributes to the following three objectives: deepening the integration of the EU insurance market, enhancing policyholder protection, improving international competitiveness of EU insurers and reinsurers and ensuring efficient supervision of insurance groups and financial conglomerates.

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4.5. Small and medium sized undertakings (Annex B.5)

The current insurance regime applies to the vast majority of insurance companies operating within the EU. The smallest insurers are exempted, but nevertheless there remain a very large number of small and medium sized companies and mutual associations that are covered, many of whom are operating in niche markets. The diversity of the EU insurance markets raises the question, whether a single one-size-fits-all approach should be taken for Solvency II, or whether the regime should be tailored to take account of the specificities of small and medium sized enterprises (SMEs).

The specificities of SMEs could be taken into account in a number of different ways. One possibility would be to develop separate regimes for large and small companies. This could be achieved either by developing two new separate regimes, or by continuing to apply the current regime to smaller insurers, whilst introducing a new solvency system for larger insurers. Another possibility is to apply the same principles to large and small insurers alike, but allow for a range of methods to be used in order to meet those principles, tailored to the nature, size and complexity of the insurer.

The options regarding the treatment of small and medium sized undertakings can thus be summarised and will be referred to in the rest of this report as follows:

- Policy Option 5.1 : Same regime for all insurers, large and small alike;

- Policy Option 5.2 : Separate regimes for large and small insurers;

- Policy Option 5.3 : Same principles for all insurers, but range of methods available to meet those principles.

Given the heterogeneity of the EU insurance market, applying the same regime to both large and small insurers (Option 5.1) is likely to result in the introduction of a system that would be too complex and costly for small and medium sized firms, on the one hand, whilst not providing sufficient incentives for larger insurers to improve their risk management, on the other.

The most direct way to take account of the specificities of smaller insurers would be to apply a separate regime to them (Option 5.2) . This approach would ensure that administrative costs were not unduly burdensome for smaller insurers and that a regulatory regime for large insurers could be introduced that was aligned to industry best practice. However, Option 5.2 would only deliver harmonised risk-sensitive solvency rules if an insurer's size is a good proxy for complexity and risk, which is not always true. The use of different solvency regimes would therefore introduce the risk that a different level of policyholder protection would be applied to large and small insurers' policyholders – e.g. if the requirements for SMEs were underestimated, this would endanger small insurers' policyholders.

Another way to take account of the specificities of smaller insurers is to apply the same principles to all insurers, whilst allowing for a range of methods to be used that take account of the nature, scale and complexity of their operations (Option 5.3). Such an approach would allow for simplified methodologies to be applied (e.g. for technical provisions and capital requirements), where an insurers' operations are relatively straight-forward. Conversely, larger insurers, or insurers with more complex risk profiles, would be required to use more sophisticated methods. Similarly qualitative requirements regarding governance, internal control and risk management would be applied in a proportionate manner. This would ensure that administrative costs are commensurate with the nature, scale and complexity of an insurer's operations, whilst at the same time providing appropriate incentives for all insurers to improve their risk management. Moreover, Option 5.3 is similar to the one adopted in the banking sector.

Option 5.3 has been retained as the best option as it most effectively meets the objective of introducing proportionate requirements for small undertakings and introducing harmonised risk-sensitive solvency standards. Even though it less effectively contributes to the harmonisation of technical provisions than Option 5.1, it is much more efficient with respect to that objective.

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A separate important question regarding the treatment of SMEs relates to whether the smallest insurers should be exempted from the regime altogether. Some small insurers are exempted from the current regime. Although, this question is not considered in the analysis above the box below provides some data regarding the impact of choosing different exemption thresholds and conditions under Solvency II.

Exemption threshold under Solvency II

The current exemption threshold is set at €5 million annual premium income, and it only applies to mutuals (~674 undertakings concerned out of a total of 1301 mutuals and 3225 non mutuals[28]). In the context of Solvency II, a couple of options for the exemption threshold have been considered: keep the current rule; or retain the current threshold of €5 million, but extend it to all legal forms of undertakings (~1638 undertakings concerned); increase the threshold to €10 million and enlarge it to all legal forms of undertakings (~1954 undertakings concerned).

4.6. Calculation of technical provisions for prudential and accounting purposes (Annex B.6)

Under the current regime, Member States generally require insurance and reinsurance companies to apply the same valuation standards for both accounting and supervisory reporting purposes, in particular with respect to the calculation of technical provisions. However, these valuation standards, including the methods applied to calculate technical provisions, vary widely from Member State to Member State.

Given the important role that the calculation of technical provisions plays in any solvency regime, this raises the question whether the calculation of technical provisions should be harmonised for supervisory purposes under Solvency II, and if so should this harmonised approach be carried over to the accounting rules.

The question is linked to international developments and Phase II of the IASB’s Insurance Contracts project, particularly now that EU listed companies are required to present IAS accounts.

The options regarding the calculation of technical provisions for prudential and accounting purposes can thus be summarised and will be referred to in the rest of this report as follows:

- Policy Option 6.1: Retain current rules regarding the calculation of technical provisions;

- Policy Option 6.2 : Harmonise and align calculation of technical provisions for both accounting and prudential purposes;

- Policy Option 6.3 : Harmonise the calculation of technical provisions for prudential purposes, but leave the calculation of technical provisions for accounting purposes unchanged.

Option 6.1 was discarded early on in the project, as the current existence of very different national rules is one of the key problems of Solvency I (See Section 2). It has negative impacts: on the whole EU industry, as it prevents meaningful comparison and fair competition across Member States; on lead supervisors and cross-border groups, who are confronted with varying financial requirements and reporting formats; and on policyholders, who are faced with greater uncertainty on the financial strength of insurers, because good practice is not encouraged and shared.

Conversely, Options 6.2 and 6.3 provide for better transparency and comparability across insurers and reinsurers, as well as for common risk-based tools for supervisors. As a consequence, they would enhance policyholder protection. On the other hand, insurers would incur significant up-front costs introducing harmonised new rules. The main drawback of Option 6.2 is that it would probably delay the whole Solvency II project, until the outcome of the IASB's work is known. This would result in considerable short-term opportunity costs. Option 6.2 was therefore discarded on efficiency grounds.

Option 6.3 was retained as a good compromise and the most effective and efficient option with respect to the following two objectives: harmonise calculation of technical provisions and harmonise supervisory methods, tools and powers. In addition, even though Option 6.3 does not provide full harmonisation with IFRS rules, it nevertheless clearly promotes compatibility with those standards since the valuation standards laid down in the draft Directive are broadly in line with IFRS latest developments.

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4.7. Calculation of capital requirements (Annex B.7)

Under the current regime the minimum solvency margin does not capture all the risks an insurer is exposed to. As a consequence, a number of Member States have introduced supplementary solvency rules. In particular, with respect to investment risk, as it is not captured in the current regime. These supplementary rules often involve the use of stress and scenario tests – i.e. capital requirements are based on the worst-case outcome from a set of scenarios applied to an insurance company's operations.

In the United States, a new Risk-Based Capital (RBC) system was introduced in the 1990s. The principle underlying the RBC system is to assign a capital requirement to each of the main risks facing insurance companies: the calculation methods used, which are more complex than the current EU system, are standardised but take account of the characteristics of each company. A cumulative capital requirement is then calculated by combining the capital requirements assigned to each risk.

However, neither the current EU regime nor the US RBC system take a full economic capital approach targeting a specific confidence level and time horizon – e.g. they are not designed with the objective of ensuring that no more than a specified percentage of insurance companies would be expected to fail over a given time horizon. In addition, neither regime allows for internal models to be used in the calculation of capital requirements instead of the standard formula.

The options regarding the calculation of capital requirements can thus be summarised and will be referred to in the rest of this report as follows:

- Option 7.1 : Update the current required solvency margin calculation;

- Option 7.2 : Introduce an advanced scenario-based approach;

- Option 7.3 : Introduce a European RBC system, similar to the RBC system in the US;

- Option 7.4: Introduce a system based on the amount of economic capital corresponding to a specific ruin probability and time horizon, either calculated using a standard formula, or an internal model.

Despite limited one-off implementation costs, Option 7.1 was discarded because of the underlying structural problems of the current solvency regime (See Section 2).

Options 7.2 and 7.3 were seriously considered as they would clearly encourage EU insurers to improve their risk management as compared to Solvency I, enhancing policyholder protection. That said, advanced scenario-based approaches may suffer from subjectivity issues (i.e. how do you simulate such a complex scenario in practice?) and a European RBC system would not properly capture complex risk interactions, nor the impact of innovative risk-mitigation techniques.

Option 7.4, by introducing an economic risk-based approach, should provide very strong incentives for EU insurers to improve their risk management, to the benefit of policyholders. Such an approach is based on the true risk profile of insurance undertakings: it captures a wide-range of financial risks, as well as interactions between risks, the impact of risk mitigation techniques, and diversification effects.

Option 7.4 will result in better allocation of capital for insurers, align regulatory requirements with industry practice, and make supervision more effective and efficient (more accurate and timely interventions by supervisors).

In addition, Option 7.4 strikes the right balance between risk-sensitivity and simplicity: using a standard formula to calculate risk-based capital requirements will limit the implementation costs for smaller insurers; and large firms are offered the opportunity to use more sophisticated methods, if desired. Implementation of internal models will nevertheless be expensive to both develop and maintain.

Option 7.4 leaves little room for interpretation when a standard formula is used (maximum harmonisation of regulatory capital requirements), thus reducing the burden for insurance undertakings operating on cross-border basis.

However, with respect to internal models, there is considerable subjectivity regarding the design, parameters and data sets to be used. Increased supervisory cooperation and coordination will be required to ensure real harmonisation in this regard. In addition, validation of internal models by supervisors will require considerable actuarial and risk management knowledge, as well as increased supervisory resources (See CEIOPS Report ).

Option 7.4 was retained as the best option, in line with the conclusions of the KPMG Report , as it effectively and consistently meets the objectives of improving the risk management of EU insurers and reinsurers, providing for a better allocation of capital resources, and advancing supervisory convergence.

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Low Level Policy Options

Following consideration of the overall direction of the new regime (high level policy options), a number of subsequent lower level policy options were analysed and compared. These options included methods for the calculation of technical provisions; the level of calibration of the capital requirements; and how the capital requirements should be designed. In addition, various options regarding the treatment of investments were considered. More detail is provided on each low level policy option below, together with a short summary setting out which option was taken and why. Detailed analysis of each option is contained in Annexes B.8-B.13.

4.8. Methods for the calculation of technical provisions (Annex B.8)

It was agreed during Phase I of the Solvency II project that the calculation of technical provisions for prudential purposes should be harmonised (See Section 4.6). However, the approach to be applied to determine the new harmonised calculation was left for Phase II of the project.

A number of options were tested in the PFS , QIS1 and QIS2 , all of which were based on a best-estimate plus risk margin approach.

With respect to the calculation of the best-estimate, the key question relates to whether cash-flows should be discounted using the relevant risk-free interest rate or not, as this option was left open to Member States under the current regime.

With respect to the calculation of the risk margin, a number of different methodologies and approaches were considered, in line with discussions taking place internationally both within the IAIS and IASB. In the PFS and QIS1 , a percentile approach was tested (75th percentile and 90th percentile). In QIS2 a 75th percentile and cost-of-capital approach were tested.

The options regarding the harmonised calculation of technical provisions for prudential purposes can thus be summarised and will be referred to in the rest of this report as follows:

- Policy Option 8.1 : Undiscounted best estimate with percentile risk margin calculation;

- Policy Option 8.2 : Discounted best estimate with percentile risk margin calculation;

- Policy Option 8.3 : Discounted best estimate and cost-of-capital risk margin calculation.

Important remark : The calculation of technical provisions on a discounted basis is broadly in line with a market consistent approach to valuation. Regarding pure unit-linked business, this policy issue is irrelevant, since unit-linked liabilities are already valued on a market-consistent basis under Solvency I and will continue to be valued in the same way under Solvency II. Another important issue regarding the calculation of technical provisions is whether financial guarantees embedded in insurance contracts should be valued on a market consistent basis or not.

When correctly applied, discounting provides a better measure of the true economic value of insurance liabilities, and promotes sound risk management, as it will require insurers to further analyse the underlying risk drivers (e.g. settlement patterns and time value of money). Furthermore, explicit discounting does not necessarily imply that the level of policyholder protection is weakened, because prudence is provided by both the inclusion of a risk margin and the imposition of capital requirements. Therefore, Option 8.1 was discarded.

With respect to the calculation of the risk margin, the percentile approach raises significant practical concerns, which counts against Option 8.2. Conversely, the cost-of-capital approach seems to be reasonably easy to compute - in particular for SMEs, as it allows for simplifications - provides the same level of prudence in most cases, and better corresponds to the way the insurance industry manages its risks.

Option 8.3 is in line with all those considerations and is expected to have a positive overall impact. In particular, the discounting rules should lead to a significant decrease in non-life insurance technical provisions (~ -15%) according to the results from QIS2 , especially in southern countries where discounting is currently unauthorised. This should put downward competitive pressure in respect of mass risk insurance (e.g. motor and household insurance) and policyholders should ultimately benefit from this decrease in costs. On the other hand, with respect to life insurance technical provisions, the impact of discounting using market rates is less material, since it is largely offset by the inclusion of expected discretionary bonuses in the best estimate and market consistent valuation of contractual guarantees.

Option 8.3 encourages insurers, both large and small, to better understand their risks, which should indirectly enhance policyholder protection and financial stability. It should also promote better capital allocation within the insurance sector and the EU economy as a whole.

Option 8.3 has been retained as the best option as it is the most effective and efficient solution with respect to the following objectives: harmonised calculation of technical provisions, introducing harmonised risk-sensitive solvency standards, harmonised supervisory methods, tools and powers, and proportionate treatment of small undertakings. In addition, it seems to be a more sustainable solution, since the most recent IFRS developments tend to rely on the same philosophy, in line with a fifth objective (i.e. compatibility with IFRS rules).

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4.9. Calibration of the Solvency Capital Requirement (SCR) (Annex B.9)

It was agreed at the conclusion of Phase I of the project that the Solvency Capital Requirement (SCR) for the new system should be based on the amount of economic capital corresponding to a specific ruin probability and time horizon, calculated either using a standard formula or internal model.

The specific choice of ruin probability and time horizon was though left to Phase II. Under QIS2 , the results were calibrated to a ruin probability of 0.5% over a one year time horizon (a working hypothesis introduced into the Framework for Consultation in July 2005). The results of QIS2 were benchmarked against the current solvency requirements in order to ascertain what the impact of using a ruin probability of 0.5% over a one year time horizon would be and whether or not it should be adjusted up or down.

However, it should be noted that the main focus of QIS2 was the design of the standard formula for the SCR, not calibration. Therefore the results and analysis provided below should be regarded as purely indicative and provisional. In particular, QIS2 focussed on solo capital requirements. Group requirements and requirements based on internal model calculations are being tested for the first time as part of QIS3. Consequently, this analysis will need to be updated in the light of QIS3. The results of QIS3 will provide a more precise indication of the overall impact on capital requirements.

The options regarding the ruin probability to be used for the SCR can thus be summarised and will be referred to in the rest of this report as follows:

- Option 9.1 : Use a 0.5% ruin probability over a one-year time horizon for SCR;

- Option 9.2 : Use more onerous capital standard – i.e. higher capital requirement;

- Option 9.3 : Use less onerous capital standard - i.e. lower capital requirement.

A Value-at-Risk measure subject to a 99.5% confidence level over a one year time horizon (equivalent to a probability of ruin of 0.5%), is believed to roughly correspond to a "secure" financial strength (or BBB) rating for an insurer.

Standard & Poor's assigns a BBB rating level to firms with "good" capital adequacy (i.e. actual capital at disposal of the firm is 100 to 125% of the minimum economic capital considered necessary). Imposing a more onerous capital standard (option 9.2) would imply asking for a higher rating, e.g. an A rating, corresponding to "strong" capital adequacy (i.e. 125% to 150%); or on the other hand, a lower rating (option 9.3), e.g. a BB rating, corresponding to "vulnerable" capital adequacy (below 100%) - See KPMG Report .

Imposing a more onerous capital standard (Option 9.2) would be preferable from a policyholder perspective, as it effectively contributes to the objective of enhancing policyholder protection. However, imposing a higher capital requirement would also increase costs for EU insurers and undermine their international competitiveness. Conversely, imposing a less onerous capital standard (Option 9.3) would be preferable from the perspective of the industry, allowing them to compete more effectively on internationally, but would provide a lower level of protection for policyholders.

The chosen ruin probability of 0.5% over a one year time horizon can be viewed in two different ways. Either that a specific insurer would be expected to fail once every two hundred years or that on an annual basis, one in every two hundred insurers will fail.

For comparison purposes, in the banking sector, the capital requirements for credit and operational risk has been calibrated to a 99.9% confidence level over a one year time horizon, whereas for market risk capital requirements are calibrated to 3 times a 99% confidence level over a time horizon of ten days[29]. Therefore, the banking approach relies on the same philosophy, even though the chosen calibration is different, depending upon the risks being considered. The higher confidence level for credit and operational risk is usually justified on the grounds of financial stability and the lower time horizon for market risk in the trading books of banks on the grounds that this business is generally short-term in nature.

Although the main focus of QIS2 was on the design of the standard formula for the SCR, rather than on its actual calibration, it did provide some initial indication of the possible impact of the new capital requirements based on a ruin probability of 0.5% over a year time horizon.

The impact of the capital requirements tested under QIS2 differed from Member State to Member State (24 countries took part to QIS2 ). Generally, the QIS2 results indicated that the SCR tested was higher than the current solvency requirements, particularly in the case of non-life business.

However, it is important to note that the baseline varies considerably from Member State to Member State, depending on:

- the current valuation criteria adopted for assets (historical cost vs. a market consistent approach);

- current valuation criteria adopted for technical provisions (e.g. whether or not technical provisions are discounted);

- the existence of additional capital requirements in some Member States on top of the current required solvency margin (e.g. the Enhanced Capital Requirement in the United Kingdom).

Therefore, a better indicator of the overall impact of the requirements tested under QIS2 is the "effective" relationship between the SCR and the Solvency I capital requirement, taking into account changes in the valuation criteria for assets and liabilities[30]. This ratio compares the new explicit capital requirement (SCR) based on economic principles with the "overall requirements" of Solvency I, including both explicit requirements (the required solvency margin) and implicit requirements (prudence embedded in the current valuation criteria for assets and liabilities, e.g. assets valued at historical cost, and no discounting of technical provisions).

In the life sector, the "nominal" relationship between the SCR and the required solvency margin indicated that the tested requirement under QIS2 was between 1 and 3 times higher than at present. However, the "effective" relationship between the SCR and the required solvency margin differed from Member State to Member State. For Member States, where assets are valued at historical cost, the life capital requirement was effectively lower than the required solvency margin (sometimes as much as 50% lower), whereas for Member States where assets are already valued on a market-consistent basis, the life capital requirement was higher than the required solvency margin.

In the non-life sector, the "nominal" relationship between the SCR and the required solvency margin indicates that the requirement tested under QIS2 was between 2.5 and 4.5 times higher than at present. However, the "effective" ratio showed a much smaller increase, once the consequences of the introduction of market consistent valuation of assets and discounting of technical provisions are taken into account.

Although caution is needed - as QIS2 did not test the new definition of capital elements eligible to cover the new requirement and did not analyse the impact of current additional capital requirements in some Member States - the impact of the requirement tested under QIS2 on the solvency position – i.e. the relationship between available capital and required capital - of firms can be qualitatively assessed.

In the life sector, eleven countries indicated that available capital under QIS2 specifications expressed as a percentage of the SCR was lower than available capital as defined under the current regime expressed as a percentage of the required solvency margin, although in most cases the percentage was still over 100%. In other words insurers would not be required to raise additional capital to meet the requirements tested under QIS2 . Conversely, six countries reported that on average capital requirements would be lower.

In the non-life sector, sixteen countries indicated that on average the ratio of available capital over capital requirements was lower under QIS2 than under the current regime. Again on average the percentage was though still over 100%. However, there were a not insignificant number of non-life insurers who would be required to raise additional capital to meet the requirements tested under QIS2 .

Overall, the QIS2 results indicated that in the case that the requirements tested under QIS2 were introduced the European insurance industry would hold sufficient capital to meet them without having to raise additional funds, even in the non-life sector where the impact was greater. However, some small non-life undertakings, mostly mono-liners and/or mutual companies reported that they would be required to raise additional capital. This was partly due to the presence of a size factor adjustment in the QIS2 specification which has been eliminated from the SCR formula that will be tested in QIS3.

Concerns were also expressed about the calibration of the capital charge for equity and property risk (corresponding to a shock of 40% of the market value of equity investments and 20% of property) in QIS2 by some stakeholders, because it was considered to be inappropriate and overly conservative. In their opinion, the proposed treatment did not properly reflect the interaction between assets and liabilities and in particular the use of equity to match long-term liabilities. Experience shows that volatility in equity is high in the short term, but less significant over the long term.

Option 9.1 has been retained as the best option, after being tested in QIS2 , as it achieves an appropriate balance between the objective of enhancing policyholder protection and improving the international competitiveness of EU insurers and reinsurers.

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4.10. Choice of a risk measure for solvency purposes (VaR vs. TailVaR) (Annex B.10)

With respect to the definition of an appropriate risk-measure so as to calculate the Solvency Capital Requirement (SCR), there was considerable debate regarding whether it should be expressed as a Value-at-Risk figure (VaR) or a Tail Value-at-Risk figure (TailVaR).

The following graph represents how VaR and TailVaR are derived from a probability distribution with a 99.5% confidence level (e.g. a 0.5% probability for the insurer to be ruined in the case of VaR) over one year.

Figure: graphical definition of VaR and TvaR

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This question does not impact the overall calibration of the SCR, as the confidence level applied to a TailVaR measure can be adjusted downwards to deliver an equivalent probability of ruin, but it is especially important for insurers and reinsurers wishing to use an internal model.

The options regarding the risk measure to be used for the SCR can thus be summarised and will be referred to in the rest of this report as follows:

- Policy Option 10.1 : Use Value-at-risk measure;

- Policy Option 10.2 : Use Tail-value-at-risk measure;

- Policy Option 10.3 : Use Value-at-risk measure, but allow insurers using an internal model to use alternative risk measures as long as they deliver an equivalent level of policyholder protection;

The main disadvantage of Option 10.1 is that VaR does not meet all the theoretical and actuarial qualities for a risk measure. These theoretical weaknesses lie behind the concerns of some supervisors calling for optimal policyholder protection. On the other hand, Option 10.1 has many practical advantages, since it is easy to understand and implement, and is already used by the majority of insurance companies and by the banking sector. Consequently, Option 10.1 would limit initial implementation costs for many companies.

Conversely, Option 10.2 establishes an excellent risk measure in theory, TailVaR, but raises numerous practical concerns: it is likely to cause significant additional costs for the industry; it introduces cross-sectoral consistency issues, as the other financial sectors refer to VaR; and TailVaR is often difficult to implement properly, and therefore subject to significant modelling error, to the detriment of policyholder protection.

Option 10.3 achieves common ground between the first two options. Indeed, it establishes VaR as a benchmark, which seems to be the most practical solution for a great number of insurers, but does not prevent companies that are willing and able to build a more sophisticated internal model to use TailVaR as a risk measure. This approach also provides flexibility to take into account technological progress.

Option 10.3 was retained as the best option, since it has very few drawbacks. Overall it is the most effective, efficient and consistent solution with respect to the following objectives: introducing harmonised risk-sensitive solvency standards, proportionate treatment of small undertakings, harmonised supervisory methods, tools and powers, and promoting compatibility of prudential supervision of the insurance and banking sector.

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4.11. Design of the SCR standard formula (Annex B.11)

The design of the SCR standard formula was left until Phase II. In QIS2 , various options were tested for each risk module in the standard formula, along with the methods for aggregating the results of each of those risk modules.

In particular, different factor- and scenario-based approaches were tested for each risk module under QIS2 and the results were compared and analysed both quantitatively and qualitatively. This analysis included consideration of the ease with which smaller insurers could perform the calculations.

The options regarding the design of the SCR standard formula can thus be summarised and will be referred to in the rest of this report as follows:

- Option 11.1 : Use scenario-based approach for all SCR risk modules;

- Option 11.2 : Use factor-based approach for all risk modules.

- Option 11.3 : Use mixed approach, scenarios for some SCR risk modules and a factor-based approach for others;

- Option 11.4 : Use mixed approach, scenarios for some SCR risk modules and a factor-based approach for others, but provide simplified factor-based approaches for those risk modules where scenarios are used;

A number of possible approaches exist to calculate capital requirements using a standard formula. These range from simple factor-based approaches (where a specified factor is multiplied by a risk exposure measure) to more complex scenario-based approaches (where insurers are required to test their solvency position against a range of adverse scenarios). Factor-based approaches (Option 11.2) benefit from being simple to describe and to calculate. Their main drawback is some lack of risk-sensitivity, as they cannot capture all the specificities of an individual insurer's risk profile. Conversely, scenario-based approaches (Option 11.1) are more risk-sensitive and potentially dynamic, but it can be difficult to determine scenarios that are truly representative of a worst case event for the vast majority of insurers, and scenario-based approaches are more complex to implement and more costly to maintain than a factor-based approach.

The SCR standard formula tested in QIS2 was based on a modular approach (i.e. individual risk exposures are assessed and then aggregated). Factor-based and scenario-based approaches were tested for each risk module under QIS2 , in order to analyse their respective impacts and qualities. The results of QIS2 pointed towards the use of a mixed approach. That is to say the use of factor based approaches for some risk modules and scenarios for others, and where a scenario-based approach was chosen, to develop simplified factor-based approaches to be used as a proxy by firms with simple risk profiles.

This approach (Option 11.4) provides large firms with incentives to improve specific areas of risk management, where a scenario-based approach is used, even though this will entail significant implementation and on-going costs for those firms. Regarding small and simple insurers, the possibility to use factor-based approaches for all SCR risk modules should ensure a straight-forward implementation of the new regime, limiting administrative costs. Improved risk analysis by both firms and supervisors should enhance policyholder protection, particularly where scenario-based approaches are used.

Option 11.4 was therefore retained, in line with the feed-back from QIS2 and in line with the conclusions of the KPMG Report , as it efficiently and effectively meets the objectives of introducing harmonised risk-sensitive solvency standards and establishing proportionate requirements for small undertakings.

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4.12. Calculation of the Minimum Capital Requirement (MCR) (Annex B.12)

At the conclusion of Phase I of the project, it was agreed that the new solvency regime should include not only a Solvency Capital Requirement (SCR), but also a Minimum Capital Requirement (MCR) calculated in a more simple and robust manner than the SCR.

The SCR and the MCR are the two extremes of the so-called "ladder of supervisory intervention". If available capital falls below the SCR, supervisors take proportionate corrective measures. In the event that available capital falls further, the severity of the measures applied is increased, and in the event that the MCR is breached ultimate supervisory action is triggered. The concept of the supervisory ladder is in line with the IAIS's Guidance Paper No. 6 on Solvency Controls Levels.

During Phase II of the project, a number of different options were discussed regarding the calculation of the MCR. These included using a percentage of the SCR (or "compact approach"), a simplified version of the SCR calibrated to a lower level of confidence (or "modular approach"), and a calculation similar to that under Solvency I.

The options regarding the calculation of the MCR can thus be summarised and will be referred to in the rest of this report as follows:

- Option 12.1 : MCR calculated as a percentage of the current solvency margin requirement;

- Option 12.2 : MCR calculated as percentage of the SCR;

- Option 12.3 : MCR calculated using simplified version of the SCR.

Option 12.1 has the advantage of ensuring continuity with the current regime and minimising implementation costs. On the other hand, it would clearly bring the disadvantages of the existing system into Solvency II, namely the lack of risk-sensitivity. This option was consequently discarded.

Option 12.2 would have the main advantage of providing automatic reassurance that there is a sufficient difference between SCR and MCR, allowing for the proper functioning of the supervisory ladder of intervention. Moreover, it would be consistent with the new risk-based framework and introduce low incremental burden on insurers. Its main drawback is that the calculation of the MCR would rely on the SCR calculation: as a consequence, national courts would be required to check all the assumptions underlying the SCR in order to verify the calculation of the MCR. Moreover, from the point of view of supervisors, the MCR would not provide additional information when compared to the SCR.

Option 12.3 corresponds to a simplified factor-based version of the SCR standard formula concentrating on the main risk categories, calibrated to a lower level of confidence than the SCR (see previous section). This would allow for some risk-sensitivity to be retained, whilst optimising for simplicity. In particular, the MCR calculation would be relatively simple for national courts to verify, in the event authorisation to take ultimate supervisory action is required. Even though relatively straight-forward, Option 12.3 would be more costly for the industry to implement than the approaches outlined in Options 12.1 and 12.2.

Data was collected on all three approaches as part of QIS2. A number of concerns were raised regarding Options 12.1 and 12.3, as they did not appear to deliver a clear hierarchy of regulatory requirements, in which the SCR was above the MCR. Consequently, two new methodologies have been developed and shall be tested in QIS3:

- a revised "modular" approach to the MCR, developed by CEIOPS in its post-QIS2 advice, along the lines of Option 12.3;

- an alternative "compact" MCR, put forward by the CEA, equal to a percentage of the SCR calculated in accordance with the standard formula or using an internal model, along the lines of Option 12.2.

Only after examining the results of QIS3, will a final decision on the design of the MCR be taken.

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4.13. Investment rules (Annex B.13)

Unlike the current regime, where the required solvency margin does not take account of investment risk, under Solvency II the SCR will capture quantifiable risks, including investment risk, to a much greater extent. This raises the question whether investment rules regarding the admissibility of assets, as well as the imposition of quantitative limits, are still necessary, and if so whether they should apply only to assets covering technical provisions, or assets covering both technical provisions and the SCR.

The current regime includes a requirement for insurers to manage their investments in a "prudent manner"; the "IORP" Directive[31] dealing with pension funds is based on the "prudent person" principle. The current insurance directives are supplemented by a series of detailed investment rules regarding the admissibility of assets covering technical provisions, as well as quantitative limits on investments. These rules are then further elaborated by additional investment rules at national level, further restricting the assets that can be used to cover technical provisions.

The "prudent person" principle is a long-established legal principle and practice governing the management of investments. The principle encapsulates the ideas of portfolio diversification and broad asset-liability matching, based on the premise that the manager of the investments should be seeking to manage them as if they were his own, with due diligence and skill, thus avoiding undue risks to the beneficiaries.

Quantitative restrictions and asset admissibility rules (which are an extreme form of quantitative restrictions – a 100% deduction) limit holdings of certain types of assets within the portfolio. Both the prudent person approach and an approach based on quantitative limits seek to ensure that there is no significant mismatch between assets and liabilities, and that assets are sufficiently well diversified and liquid.

The options regarding investment rules can be summarised as and will be referred to in the rest of this report as follows:

- Option 13.1 : Retain current investment rules and Member State options;

- Option 13.2 : Introduced harmonised investment rules;

- Option 13.3 : Abolish investment rules but retain the prudent person principle;

- Option 13.4 : Abolish investment rules and prudent person principle.

The current investment rules (Option 13.1) provide policyholders with assurance that assets backing technical provisions will be invested in line with quantit