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Solvency II: Pillar 1 – Own funds
Own funds are defined differently under Solvency II than under the present supervision framework. Under Solvency II an undertaking’s own funds consist of basic own funds and ancillary own funds. Solvency II also tightens up the rules on the own funds eligible for covering the regulatory capital requirements (known as the ‘eligible own funds’).
Basic own funds
The basic own funds consist of (i) the excess of assets over liabilities, and (ii) subordinated liabilities. Examples of basic own-fund items are paid-up share capital, share premium reserve and the reconciliation reserve.
Ancillary own funds
Ancillary own funds consist of items other than basic own funds which can be called up to absorb losses. These are therefore items that have not yet been paid in or called up. Once an ancillary own-fund item has been paid in or called up, it will be treated as a basic own-fund item and cease to form part of the ancillary own-fund items. Examples of ancillary own funds are unpaid share capital or initial fund that has not been called up, letters of credit and guarantees.
Supervisory approval of ancillary own-fund items required
Ancillary own-fund items require the prior approval of the supervisory authority in order to be taken into account when determining own funds. The supervisory authority bases its approval on an assessment of matters such as: (i) the status of the counterparties concerned in relation to their ability and willingness to pay; (ii) the recoverability of the funds; and (iii) any information on the outcome of past calls made by the insurer for such ancillary own funds.
Application may be made to De Nederlandsche Bank (DNB) for approval of ancillary own-fund items from 1 April 2015. More information about this will follow in due course.
Classification of own funds into tiers
Under Solvency II own-fund items are classified into three tiers. This classification depends on such factors as whether they are basic or ancillary own-fund items and the extent of their permanent availability and subordination.
The basic own funds can be classified in Tiers 1, 2 or 3. Tier 1 funds are the highest grade capital, for example paid-up share capital. Ancillary own-fund items may not be classified in Tier 1, only in Tiers 2 or 3.
Eligible own funds
The classification into tiers is relevant to the determination of eligible own funds. These are the own funds that are eligible for covering the regulatory capital requirements – the solvency capital requirement and the minimum capital requirement. For example, the minimum capital requirement must be covered by Tier 1 and Tier 2 capital and may not therefore be covered by Tier 3 capital. The extent to which the tiers are eligible to cover the capital requirements is set out in the implementing measures (also known as delegated acts).
Transitional measure own funds
To ensure a smooth switch to Solvency II, a transitional scheme applies to own funds. This transitional scheme applies to own-fund items that do not comply with the requirements set by Solvency II for Tier 1 or Tier 2 basic own funds, but do largely qualify as eligible own funds under the current supervision framework. If the own-fund item satisfies the criteria of the transitional scheme, it may be treated – depending on its exact characteristics – as Tier 1 or Tier 2 basic own funds under Solvency II for a maximum of ten years.
Relevant articles: Articles 87-99 and Article 308(3), paragraphs 9 and 10 of the Solvency II Directive.