Solvency Requirements

For the insurance undertaking’s capital requirement under supervisory law, the solvency capital it is required to maintain must first be calculated.²⁰ The relevant provisions are found in arts. 100 to 127 of the Solvency II Directive,²¹ arts. 75 to 235 of the DVO-E, some Level 3 papers, and secs. 87 to 112 of the VAG [German Insurance Supervision Act] 2012. Here, the VAG [German Insurance Supervision Act] 2012 replaces the term “Solvenzkapitalanforderung” found in the German-language version of the European law—and generally rendered in English as “Solvency Capital Requirement” or “SCR”—by the alternate term “Solvabilitätskapitalanforderung” [in English: Solvability Capital Requirement]. These provisions also govern the use of the “standard model” and the partial or fully internal model according to which the relevant Solvency Capital Requirement is determined. The calculation of required capital is no longer centered on business volume as measured by premium income but rather on the risk exposure of the insurance undertaking. The insurance supervisory regime specifies individual risk modules for this purpose which must be considered when determining the Solvency Capital Requirement. In order to ensure the most uniform procedure possible for all insurance undertakings in the EU and European Economic Area,²² highly detailed requirements in this respect appear in all three levels of the Solvency II system.

The connection between the Solvency Capital Requirement with own funds is established in arts. 100, para. 1, 102, para. 1, subpara. 2 of the Solvency II Directive—and reflected in sec. 80, para. 1, sent. 1 of the VAG [German Insurance Supervision Act] 2012—according to which all insurance undertakings must “hold eligible own funds covering the Solvency Capital Requirement”. In other words, an insurance undertaking is no longer in compliance with its Solvency Capital Requirement when the ratio of own funds to the Solvency Capital Requirement, referred to here as the “solvency ratio”, is below 100 %.

The Solvency Capital Requirement must be calculated and reported to the supervisory authorities at least once a year according to arts. 100, para. 1, subpara. 1, 102, para. 1 subpara. 1 of the Solvency II Directive, or sec. 89, para. 1 of the VAG [German Insurance Supervision Act] 2012. Under art. 101 of the Solvency II Directive or sec. 88 of the VAG [German Insurance Supervision Act] 2012, the calculation assumes the undertaking is a going concern, and all quantifiable risks to which the undertaking is exposed must be accounted for.

In addition to the Solvency Capital Requirement, supervisory law also requires the calculation of a Minimum Capital Requirement for an insurance undertaking. While the German-language version of the Solvency II Directive provides the term “Mindestkapitalanforderung” in art. 128, it is often replaced by the English “Minimum Capital Requirement” (MCR) in practice. Details on the Minimum Capital Requirement are found in arts. 128 to 131 of the Solvency II Directive, arts. 226 to 242 of the DVO-E, and draft regulations at Level 3. The VAG [German Insurance Supervision Act] follows the terminology of the German-language version of the European law in this case—unlike with the Solvency Capital Requirement—in secs. 213 f. of the VAG [German Insurance Supervision Act] 2012.

The Minimum Capital Requirement draws a line in the sand for capital resources held by insurance undertakings. If the line is crossed, “policyholders and beneficiaries are exposed to an unacceptable level of risk were insurance and reinsurance undertakings allowed to continue their operations”—as stated in art. 129, para. 1(b) Solvency II Directive, with the equivalent in sec. 113, para. 1 of the VAG [German Insurance Supervision Act] 2012. The Minimum Capital Requirement can be met only with eligible basic own funds, meaning the highest class of own funds.²³ There are also numerous additional rules—such as quantitative floors and a low confidence level for the determination—intended to ensure that an insurance undertaking covers the Minimum Capital Requirement. Unlike the Solvency Capital Requirement, the Minimum Capital Requirement must be calculated and reported to the supervisory authority each quarter.²⁴

The Solvency II Directive governs “The Supervision of Insurance and Reinsurance Undertakings in a Group” separately, under Title III with arts. 212 to 266. Art. 212, para. 1 (c) of the Solvency II Directive defines the term “group”. Under art. 213, para. 1, subpara. 2 of the Solvency II Directive—and correspondingly in sec. 231, para. 1, sent. 2 of the VAG [German Insurance Supervision Act] 2012—the “provisions of this Directive which lay down the rules for the supervision of insurance and reinsurance undertakings taken individually” generally apply to undertakings that are part of a group. The extent to which the group is subject to special supervision as an insurance group can be found in art. 213, para. 2 of the Solvency II Directive or. sec. 231, para. 2 of the VAG [German Insurance Supervision Act] 2012. This provision provides a detailed delineation on which group supervision rules apply to various types of group structure. Accordingly, the rules for solvency supervision in arts. 218 ff. of the Solvency II Directive and likewise in secs. 236 ff. of the VAG [German Insurance Supervision Act] 2012 apply to only two types of groups. The first are groups where the parent undertaking is an insurance or reinsurance undertaking²⁵ that participates in any insurance or reinsurance undertaking. The second are groups where the parent is an insurance holding company²⁶ with a head office in the Community and that, again, participates in any insurance or reinsurance undertaking.

Art. 218, para. 1 of the Solvency II Directive mandates supervision of the “solvency of the group” and provides the rules governing this in arts. 218 to 243 of the Solvency II Directive. The DVO-E expands on these in arts. 321 to 334. The VAG [German Insurance Supervision Act] 2012 seeks to implement the Directive’s rules in secs. 236 ff. Many of the rules on solvency supervision at the group level correspond to the solvency supervision rules at the level of the individual undertaking. This is true, to start with, for eligible own funds and the Solvency Capital Requirement at the group level according to arts. 218, paras. 2 and 3; 230, paras. 1, subpara. 2 (a); 233, para. 1 (a), para. 2 of the Solvency II Directive, or secs. 236, paras. 2 and 3; 247, para. 1, sent. 2; 251, para. 1, no. 1, and para. 2 of the VAG [German Insurance Supervision Act] 2012. Other examples include the annual calculation frequency for the Solvency Capital requirement at group level in art. 219, para. 1, subpara. 1 of the Solvency II Directive, or. sec. 237, para. 1, sent. 1 of the VAG [German Insurance Supervision Act] 2012; the basis for a supervisory review process of group solvency requirements in art. 218, para. 4, 247 ff. of the Solvency II Directive or secs. 236, para. 1 and 261 ff. of the VAG [German Insurance Supervision Act] 2012 as well as in individual regulations such as art. 244 f. of the Solvency II Directive or secs. 259 f., of the VAG [German Insurance Supervision Act] 2012; or the establishment of reporting duties on the part of the undertaking when the solvency capital requirement is not met for the group in art. 218, para. 5 of the Solvency II Directive or sec. 266, para. 3 of the VAG [German Insurance Supervision Act] 2012; and for the valuation of assets and liabilities in arts. 224, and 75 of the Solvency II Directive or sec. 69 of the VAG [German Insurance Supervision Act] 2012.

Additional supervisory requirements specifically for the solvency of groups, however, are evident because many special issues related to solvency emerge when undertakings are combined into a group. They include issues such as which of the combined undertakings to include in the solvency calculation at the group level, and to what extent (art. 221 of the Solvency II Directive or sec. 239 of the VAG [German Insurance Supervision Act] 2012); the prevention at the group level of “double gearing” in which the same eligible own funds are counted multiple times when calculating solvency capital (art. 222 of the Solvency II Directive or sec. 240 of the VAG [German Insurance Supervision Act] 2012); and the exclusion in the group solvency calculation of capital created internally through reciprocal financing of group undertakings (art. 223 of the Solvency II Directive or sec. 241 of the VAG [German Insurance Supervision Act] 2012). Added to this are detailed rules on the calculation methods for group solvency (arts. 220 and 221 ff. of the Solvency II Directive or secs. 238 and 239 ff. of the VAG [German Insurance Supervision Act] 2012). Essentially, there are two calculation methods available: a calculation based on a consolidated financial statement, referred to as the “standard method”, and the deduction and aggregation method, or “alternative method”.²⁷ These are applicable based on the criteria of art. 220, para. 2 of the Solvency II Directive or sec. 238 of the VAG [German Insurance Supervision Act] 2012. A few additional provisions on monitoring group solvency for groups with a centralized risk management function (arts. 236 ff. of the Solvency II Directive or secs. 253 ff. of the VAG [German Insurance Supervision Act] 2012) complete the series of rules governing the solvency requirements for groups. Nevertheless, there are still unanswered questions that emerge from the Directive’s rules on the solvency requirements for groups, primarily with respect to determining eligible own funds in light of the two different calculation methods for group solvency.²⁸

Holding first place on the list of the problems brought on by solvency supervision is complexity. Highlighted in this regard pars pro toto are the detailed supervisory requirements for own funds and their valuation at market price under art. 75 of the Solvency II Directive or sec. 69 of the VAG [German Insurance Supervision Act] 2012 for individual undertakings and under art. 224 of the Solvency II Directive or again sec. 69 of the VAG [German Insurance Supervision Act] 2012 for groups; also, the qualitative and quantitative criteria for eligibility, which are found for individual undertakings in arts. 93 ff. and 98 ff., respectively, of the Solvency II Directive or secs. 82 ff. and 85 f., respectively, of the VAG [German Insurance Supervision Act] 2012, and for groups in arts. 222 and 223 of the Solvency II Directive or secs. 240 f. of the VAG [German Insurance Supervision Act] 2012.⁴³ This also applies to the different rules for the Solvency Capital Requirement and the Minimum Capital Requirement. The complexity of the provisions in these three areas, with 59 articles in the Solvency II Directive at the first level alone, increases many times over at the second and third regulatory levels. At the second level alone, the draft implementing measures contains 183 articles covering own funds, the Solvency Capital Requirement and the Minimum Capital Requirement.

In the existing laws, the fundamental principles-based approach has been abandoned. It was the starting point for the Solvency II idea⁴⁴ and is still given lip service in Brussels today. Regardless of the level of normative detail, however, the problem in the relationship between a basis in principles and solvency requirements is not so much in the scope and depth of the solvency provisions. Instead, it lies in the all too programmatic requirement for the principles-based approach as a general theme of Solvency II. For the new risk-focused solvency supervision, however, such a requirement was a poor fit from the outset. This is so because the capital resources crucial to the existence of the insurance undertaking and therefore to the rise and fall in the claims of the policyholders and insureds as creditors, cannot be handled simply with indefinite supervisory requirements such as “adequacy” and “self-assessment”. Required in this area instead are additional normative requirements with the greatest possible definitiveness. Their complexity and sophistication mirrors that of modern life.

Thus a failure of the proposed conversion from a system of binding rules to a system based on expansive principles is unavoidable in this area. As a significant factor in the internal market for insurance, the capital charges necessitate essentially unified solvency rules for all insurance undertakings. The solvency discretion provided in the system can apply only to the individual risk exposure of each insurance undertaking and not to the basic issue of required solvency and its determination. Anything else would mean regulatory arbitrage, inefficient allocation proceedings, and, from a legal perspective in particular, contestable unequal treatment.⁴⁵ This is why the Solvency II Directive emphasizes the principle of equivalent treatment of all insurance undertakings as a basis for solvency supervision directly in the solvency provisions of arts. 77, para. 5, subpara. 2, 104, para. 5, 106, para. 2 and 111, para. 1.

The principle of equivalent treatment⁴⁶ highlights a matter brought on by the complexity of the solvency requirements. An initial aspect of this is seen in a problem facing small and medium sized undertakings⁴⁷: The new risk-focused solvency requirements offer the possibility, at the group or individual level of the undertaking, to use parameters specific to that undertaking via internal models in the interest of obtaining better, meaning lower, solvency requirements. But these models are only appropriate for a few insurance undertakings because of their complexity and the associated cost, which is widely acknowledged to be very high. Currently in Germany the number of such models planned, as indicated by pre-applications at the BaFin [Federal Financial Supervisory Authority], is said to be in the single digits. For small and medium sized insurance undertakings which are nevertheless broadly diversified, the option is de facto unavailable for the most part.

This raises the issue of equivalent treatment of insurance undertakings under supervisory law, given that, in line with a de facto restriction on access, only large insurance undertakings are likely to be able to use internal models while small and medium sized insurance undertakings are blocked from doing so because of the expense it entails.⁴⁸ It has also been heard from large insurance undertakings in the process of pre-applying for internal models that the expense is very high, even for them. Further, they question whether it will be of any ultimate benefit to their solvency requirements.

Against this background, the supervisory consequence of the equivalent treatment problem can only be that the supervisory authorities for now have a responsibility to monitor whether the use of full or partial internal models leads, on average, to marked improvement in the solvency of the relevant undertakings. Supervisory authorities will be aided in this respect by their power under art. 112, para. 7 of the Solvency II Directive or sec. 102, para. 7 of the VAG [German Insurance Supervision Act] 2012 to require insurance undertakings to submit an alternative estimate of the Solvency Capital Requirement based on the standard model after their internal model has been approved. If a clear solvency advantage for insurance undertakings using an internal model is revealed,⁴⁹ the supervisory authorities are required to introduce this overall by means of future law in a review of solvency supervision under the Solvency II system. Most significantly, however, the effect with respect to substantive realization of equivalent treatment under supervisory law that already ensues in the present law from the de facto block on the use of internal models for small and medium sized insurance undertakings with broad insurance operations⁵⁰ is that the supervisory authorities will liberally approve their use of undertaking-specific parameters in the standard model according to art. 104, Abs. 7 of the Solvency II Directive or sec. 100, para. 2 of the VAG [German Insurance Supervision Act] 2012 based on the principle of proportionality⁵¹ just as liberally as they allow the option of a simplified calculation when justified by the absence of risk complexity under art. 109 of the Solvency II Directive or sec. 100, para. 1 of the VAG [German Insurance Supervision Act] 2012.⁵²

The second aspect of potential unequal treatment in the context of complex solvency requirements affects the “monoline” insurer. These are specialty insurance undertakings in such areas as legal defense insurance, animal insurance, and weather insurance for agriculture. Because of their focused risk position⁵³ the standard model is clearly not suitable.⁵⁴ Therefore, regardless of their size within the competitive arena over the long term, they are de facto forced to choose a partial internal model or make extensive use of deviations from the standard formula that are specific to their undertaking. Alternatively the supervisory authorities can require that such undertakings apply parameters specific to the undertaking for certain risk modules in accordance with art. 110 of the Solvency II Directive or sec. 101 of the VAG [German Insurance Supervision Act] 2012, or use an internal model in accordance with art 119 of the Solvency II Directive or sec. 87, para. 2 of the VAG [German Insurance Supervision Act] 2012. In terms of supervision, the effect once again is that these types of applications must be liberally approved based on the principle of proportionality. Conversely, however, the supervisory authorities should use restraint in exercising their discretion when faced with a contrary decision by insurance undertakings, even in mandating the use of company-specific parameters in the standard model or the internal model instead of the standard model.

Recital 54 of the Solvency II Directive states that the calculation of technical provisions should be, i.a., “in line with international developments in accounting and supervision”. Further, under arts. 88, no. 1 and 224 of the Solvency II Directive in combination with. art. 75 of the Solvency II Directive or under sec. 69, paras. 2, 3 of the VAG [German Insurance Supervision Act] 2012, both assets and liabilities must be valued at market value at the group level and the level of the individual undertaking. Thus, under art. 75, para. 1 of the Solvency II Directive assets and liabilities are “valued at the amount for which they could be exchanged between knowledgeable willing parties in an arm’s length transaction” or “transferred or settled” under the same terms. This definition of fair value is based on the definition from the International Financial Reporting Standards (IFRS) in International Accounting Standard (IAS) 39.9. Unlike other insurance undertakings, this is nothing new in the consolidated financial statements for insurance undertakings based in the capital markets within the meaning of sec. 264d of the HGB [German Commercial Code] due to the market valuation principles in IFRS accounting that apply to many of the assets in accordance with secs. 290 and 315a of the HGB [German Commercial Code]. What is new, however, is the definition’s extension to all assets and all insurance undertakings.

Arts. 5 to 11 of the DVO-E contain further details. Art. 7 V3, para. 1 of the DVO-E presumes a valuation according to market prices in active markets as basic policy. If such market price is not available, para. 2 refers to modeling based on active markets that exist for similar assets and liabilities. If values cannot be determined in this way either, then paras. 4 and 5 provide for alternative valuation methods that make maximum use of relevant market inputs and rely as little as possible on undertaking-specific inputs.

Thus the objective pursued by Solvency II is essentially a market-consistent valuation of assets and liabilities. But market values fluctuate constantly and sometimes considerably. This can generate considerable uncertainties and disparities for the solvency-related requirements on the asset side of the insurance undertaking’s economic balance sheet and solvency statement,⁵⁵ which are definitive in this regard. This high volatility is further exacerbated by the extensive use of models to determine unavailable prices on both sides of the balance sheet, but particularly on the liability side.⁵⁶

Of particular interest for application of the law are the liabilities side and the confidence level prescribed in the Solvency II system for fulfillment of obligations. The intent of the Directive is to “ensure that ruin occurs no more often than once in every 200 cases or, alternatively, that those undertakings will still have at least a 99.5 % probability of meeting their obligations to policyholders and beneficiaries arising over the following 12 months.”⁵⁷ Accordingly, the 99.5 % confidence level for a year is mandated in arts. 101, para. 3, subpara. 2; 104, para. 4, subpara. 1; 122, paras. 1 and 2; and 129, para. 1 (c) of the Solvency II Directive—likewise in secs. 88, para. 2, sent. 4; 91, para. 3, sent. 1; and 109, para. 2, sent. 2 of the VAG [German Insurance Supervision Act] 2012.⁵⁸ The same applies at the group level under arts. 218, para. 2, 3; 230, para. 1, subpara. 2 (a); 233, para. 1, (a), and para. 2 of the Solvency II-Directive or secs. 236, 247, and 251 of the VAG [German Insurance Supervision Act] 2012.

Calibrating the Solvency Capital Requirements on this “200-year event” is unsubstantiated and cannot be derived as statistically “right”. This criterion shares that trait with almost all quantitative limits established by the law.⁵⁹ And the legislator is given a great deal of latitude in setting commercial law under the constitution. The legislator may “pursue all appropriate economic policy as long as it complies with the constitution, and fundamental rights in particular (. . .). The legislator has a large degree of freedom in formulating (the law).”⁶⁰ Since this also includes the “law on politico-economic failure”,⁶¹ questionable models other than irrational excesses with no relevance in the present context must be accepted as an exercise of the legislative prerogative to estimate.

This applies as well to “zero-risk weighting”, i.a., of bonds issued by EU/European Economic Area Member States, referring to their acceptance at nominal value without additional coverage by own funds in the market risk models according to arts. 13, no. 31 and 105, para. 5, subpara 2 (d) of the Solvency II Directive or secs. 8, no. 26 and 95, para. 2, sent. 1, no. 4 VAG [German Insurance Supervision Act] 2012 regardless of whether the government bonds in question are issued by Germany, Italy, or Greece. Insurance undertakings should correct this obvious distortion—which arose with the QIS 5 study⁶² and is now expressly provided for in Art. 163 SR7, para. 3 (b) of the DVO-E⁶³—of the Solvency Capital Requirements of Pillar I of Solvency II, and indeed at the level of the Own Risk and Solvency Assessment (ORSA) in Pillar II.⁶⁴ This discrepancy is partially to be corrected in the exercise of solvency supervision in that a capital add-on cannot be ordered by the authorities⁶⁵ based on these ORSA evaluations.⁶⁶

Another example of volatility of the Solvency Capital Requirements arises with the interest rate yield curve in life insurance. Under art. 77, para. 2, of the Solvency II Directive or sec. 72, para. 1 VAG [German Insurance Supervision Act] 2012, this determination is the basis for the valuation of technical provisions according to a hypothesis that a default-free investment is possible at this interest rate. An interest rate reduction requires higher technical reserves under the market-based valuation and thus additional own funds coverage is required.⁶⁷ In view of the long-term nature of the life insurance business and the assumption of corresponding interest guarantees, even small changes in the yield curve have significant impact on the solvency requirements.⁶⁸ German life insurance undertakings are particularly sensitive to this. They hold large amounts of fixed-interest bonds whose average terms do not correspond to those of the average interest guarantees, which results in “duration mismatch”. In contrast, foreign EU life insurances pass the risk of changing interest rates to the policyholder with investment risk by focusing on fund-linked life insurance.

For liquid investment securities beyond the 20-year limit that are not—at least not sufficiently traded on the market, a future projection of interest rates is required. In the current state of discussions, the projection is obtained through an extrapolation in accordance with art. 39 IR4 of DVO-E which begins, according to Recital 20 of the DVO-E, after 20 years. On the basis of the “Forward Rate” in national economies,⁶⁹ this extrapolated interest yield curve transitions in the 60th year⁷⁰ to the “Ultimate Forward Rate” (UFR) in accordance with art. 40 IR5 of the DVO-E.⁷¹ Ultimately, the yield curve amounts to an assumed development of interest rates that provides insurance undertakings with a specific interest rate for future decades that they can apply as the assumed risk-free rate under supervisory law. It is based on hypothetical scenarios in the absence of actual market data. After a few earlier divergent drafts, the approach on which the Level 2 rules are based still appears more politically motivated than based in economics when one considers the transition methodology applied for years 20 through 60 and the resulting determination of the Ultimate Forward Rate after that in the amount of 4.2 %,⁷² which consists of 2 % inflation and 2.2 % real interest in accordance with the criteria of art. 40 IR5, para. 2 of the DVO-E.⁷³ Relatively small changes in the actual assumptions raise or lower the capital requirements for insurance undertakings by up to several 100 % factors. Based on the assumed market situation, the same undertaking is considered over-capitalized at one point and under-capitalized at another.

This method of determining the interest rate yield curve and, above all, its individual elements by means of a delegated legal act of the EU Commission leads to a fundamental legal question. Art. 290 of the Treaty on the Functioning of the European Union (TFEU) expressly provides for such legal acts and art. 86 (a) of the Solvency II Directive even assigns determination of the “relevant risk-free interest rate term structure” to the Commission. European primary law sets the following restriction for all such delegation in art. 290, para. 1, subpara. 2, sent. 2 of the TFEU: “The essential elements of an area shall be reserved for the legislative act and accordingly shall not be the subject of a delegation of power”. This is to prevent the adoption of binding legislation without formal legislative procedure, in alignment with art. 289, para. 3 of the TFEU. On the other hand, delegation provides relief to the EU legislator from the need to overload formal EU law with technical details.⁷⁴ However, the three elements of the yield curve provided are not simply technical details. They play a critical role in deciding on market admission or exit and determining the competitive position of insurance undertakings in the internal market by establishing the criteria for required solvency resources.

Especially in view of the various conceptions of cash-value life and pension insurance with fixed guarantees in Germany and fund-linked life and pension insurance without such guarantees in many other Member States of the European Union, particularly the United Kingdom and Ireland, what emerges as a matter of fact and a matter of law is clear: not the determination of technical details at all, but rather systems competition in supervisory clothing. While with cash-value life insurance the capital costs for insurance undertakings in the context of future interest rate trends become the decisive competitive factor,⁷⁵ the risks in fund-linked insurance arising from capital investments—which include interest rate development risk—are essentially passed to the policyholder. Thus the content of the interest rate yield curve and the determination of methodology for its calculation is not just a matter of insignificant technical detail that can be regulated without formal legislative action by the EU. It is a central element of the normative system, and specifically, of supervisory law for insurance undertakings. Since this element of the capital charges of insurance undertakings also controls the pricing of insurance protection for private pensions,⁷⁶ the object of these material determinations of the interest rate yield curve is not the insurance supervision regime alone, but the functioning of private group pensions in Germany.

The Solvency II legislator is, in fact, aware of the problem of volatility. But the result is mainly that the volatility of individual risk factors is supposed to have explicit influence on the calculation of solvency requirements. This is seen for example in art. 105, para. 3, subpara. 2 (a) to (f); para. 4, subpara. 2 (a); and para. 5 of the Solvency II Directive or sec. 93 of the VAG [German Insurance Supervision Act] 2012, and thus in particular for the market risk defined in art. 13, no. 31 of the Solvency II Directive or sec. 8, no. 26 of the VAG [German Insurance Supervision Act] 2012. With rules of this nature, however, the European legislator is attempting only to integrate the volatility of individual risk factors into the solvency capital calculation. These rules are not concerned with confronting the volatility of the Solvency Capital Requirement as such from a supervisory perspective. This goal is pursued by the Directive only marginally, such as with the so-called shock absorbers under art. 106, para. 3 of the Solvency II Directive or sec. 97, para. 3 of the VAG [German Insurance Supervision Act] 2012 or at the level of general supervisory authority.⁷⁷

The extent to which the calculation methodology determines the solvency requirements for insurance undertakings is revealed, for example, in the three tiers of the qualitative classification system of own funds under art. 93 of the Solvency II Directive or sec. 82 of the VAG [German Insurance Supervision Act] 2012.⁷⁸ In the QIS 5 study, German insurance undertakings assigned 97 % of their own funds to Tier 1. This has definite consequences—positive for insurance undertakings—on the quantitative own-funds limits in the form of Tier limits under art. 98 of the Solvency II Directive secs. 85 f. of the VAG [German Insurance Supervision Act] 2012. Without further explanation, the BaFin [Federal Financial Supervisory Authority] commented on this as part of its QIS 5 study as follows: “The BaFin is unconvinced of the validity of these results”.⁷⁹ Two sides of the same coin, two completely different views: while the qualification of own funds by insurance undertakings generally anticipates no relevant market effects, the BaFin finding suggests the opposite. Both views relate to the same insurance supervisory regime requirements and implementation in actuarial assumptions.

How much the solvency of insurance undertakings can fluctuate overall under the proposed Solvency Capital Requirements is further proven by example in the solvency calculation according to the QIS 5 study of the EU Commission. For this recent impact study, the BaFin [Federal Financial Supervisory Authority] referred to a “volatility of the approach to determining coverage overall” in its assessment of the solvency requirement for life insurance.⁸⁰ In concrete terms, this means that for one and the same undertaking in the context of the QIS 5 study solvency cover could be anywhere between 80 % and 300 % in modeling based on various parameters used.⁸¹

Rules that enable such a range of results that have serious regulatory consequences can hardly be the legal basis for supervisory action consistent with basic rights. Therefore, after the final determination of the solvency rules on the three levels, it would be necessary to review, first and foremost, whether the supervisory requirements with the individual criteria are entirely indeterminate or if it is only in their method of implementation that these types of varying determinations emerge due to justifiable differences of actuarial opinion. If the first case turns out to be true, it would be difficult under current administrative and constitutional law to find in such effective legal bases for administrative action. If the second case holds true, the pluralistic methodology would need supervisory containment on a factually convincing basis that is then written into the laws. In both cases, therefore, as all of the examples show, some follow-up work and fine tuning with respect to this problem of volatility from the legal perspective must still be performed for a legally certain implementation, no matter what the concrete solvency requirements are. From a legal perspective two topics have particular significance to these as yet outstanding corrections, namely the valuation and projection discretion of the legislator and the supervisory authorities who implement the legislative requirements.⁸²

Closely associated with the volatility of the solvency requirements and even partly inherent in them is a corresponding procyclicality. This is already clear in the relationship between external ratings to capital investments and supervisory solvency requirements. If the ratings of investments, equities, or other capital investments of the insurance undertaking decline, their solvency requirements increase while investment conditions simultaneously deteriorate. The same applies to the relationship between falling interest on capital and the actuarial interest commitments for cash-value life and pension insurance, which leads not only to higher solvency requirements but also to a deterioration of new business. The procyclicality within this means an even stronger impact from economic trends that affect the solvency requirements of insurance undertakings.⁸³ The same holds true for the rigid 99.5 % value-at-risk confidence level,⁸⁴ which is specifically based on current fair value.⁸⁵ In fluctuating economic cycles, the respective worst- or best-case scenarios follow, distorting reality in a procyclical way.⁸⁶

For long-term contracts, the solvency capital system of Solvency II attempts to partially soften the negative effects unleashed by distortions in the financial markets on the solvency of insurance undertakings. Behind this is the assumption that policyholders will largely maintain their contracts even during financial market distortions. In these cases and under certain conditions a temporary release of insurance undertakings from the solvency requirements seems reasonable.

An instrument for this is the “matching premium” under Recital 24 ff. and arts. 37 IR1, para. 1, (c), 42bis and 42ter of the DVO-E. This constitutes a premium to the risk-free interest rate, with the result that the discounted obligations of the regulation’s addressee to the policyholder are lower and are therefore subject to lower requirements for own funds. The same is supposed to happen as a type of symmetrical adjustment through a reduction to the yield curve if capital investments perform well, with the result that the value of obligations rises. Due to the numerous conditions for applicability of the premium according to the DVO-E—for example, portfolios of obligations and assets that are separately held, hedged, and separately managed—these premiums are likely to yield little significance for insurance undertakings in Germany, unlike for other Member States, based on the current draft regulations.

A significant contribution to dampening procyclical effects could be made, however, by the “counter-cyclical premium” (CCP) under arts. 37 IR1 no. 1 (b) and 41 IR6 of the DVO-E. This is the successor instrument to the illiquidity premium that had been the subject of the QIS 5 study.⁸⁷ Like the matching premium, this premium is supposed to moderate excessive capital requirements resulting from long-term guarantees made by insurance undertakings.

The counter-cyclical premium faces considerable legal reservations⁸⁸ from several perspectives. To begin with, it is not provided for in the primary law, which is also true of the matching premium. The rule then cedes two critical decisions to a single authority alone, namely EIOPA, through a delegated legal act of the EU Commission. Since the premium is expressly “zero” under normal conditions, it takes effect, according to art. 41 IR6, para. 1 of the DVO-E, only in “periods of stressed markets”.⁸⁹

The first critical decision, namely as to whether such a period is present and its duration, is made solely by EIOPA. The DVO-E provides three criteria for this, each of which depends on a number of undefined legal terms. Thus one criterion is whether there is a “fall in financial markets which is unforeseen, sharp and steep”.⁹⁰ If EIOPA determines that this situation exists, it alone also makes the second critical decision, that concerning the starting level of the premium. It likewise determines, on its sole authority, reductions to the premium each quarter after the first year of introduction, and on any increases to it each quarter immediately after introduction.

All of these rules and the decisions based on them are central to insurance supervisory regime determinations. They specifically affect the criteria for the Solvency Capital Requirement itself and other measures taken by insurance undertakings. Under art. 41 IR6, para. 6 of the DVO-E, for example, insurance undertakings are required to submit solvency capital calculations to the supervisory authority under the hypothetical assumption of an anti-cyclical premium of zero, and in cases where the solvency capital is insufficient, to submit a corresponding recovery plan. While the former burdens the undertaking with expense and represents a measure of supervisory relief, the latter is eyebrow-raising and inconsistent with the intent of the anti-cyclical premium. If its specific intention is to provide adjustment to Solvency Capital Requirements in turbulent financial markets, EIOPA cannot simultaneously demand that undertakings submit plans for a restoration of the solvency capital requirement assuming stable financial market conditions—and all of this in the guise of technical rules without any formal supervision legislation from the EU and thus without any influence of the Member States on the resulting material legislation. Such legislation, therefore, has no democratic legitimacy.

A general starting point for the consideration of procyclical effects, as well as the volatility of own funds, in the supervision of insurance undertakings is actually found in art. 28, para. 2, of the Solvency II Directive or sec. 289, para. 1, sent. 4 of the VAG [German Insurance Supervision Act] 2012, which states the following: “In times of exceptional movements in the financial markets, supervisory authorities shall take into account the potential procyclical effects of their actions”.

The Statement of Reasons for sec. 289, sent. 4 of the VAG [German Insurance Supervision Act] 2012, which implements the regulation, presumes the following, which is very restrictive and hardly definable: “The exceptional movements in the financial markets mentioned in sentence 4 refer to situations that are graver than the normal lows of an economic cycle but that do not necessarily occur with the same crisis-like intensity and dynamic of an exceptional fall in financial market within the meaning of 125, para. 4”. The passage referred to, sec. 125, para. 4 of the VAG [German Insurance Supervision Act] 2012 implements art. 138, para. 4 of the Solvency II Directive which contains the regulation for situations where the solvency capital requirement is not covered. Based on the prior determination of an “exceptional fall in financial markets”, once again by EIOPA,⁹¹ the supervisory authority can “extend by an appropriate period of time” the deadline prescribed for implementation of the recovery plan in these specific cases. On the other hand, art. 28, para. 2 of the Solvency II Directive or sec. 289, para. 1, sent. 4 VAG [German Insurance Supervision Act] 2012 provides a general rule applicable to all supervisory actions in the scope of solvency supervision. This general rule must therefore be observed in the context of supervisory discretion and the proportionality of supervisory intervention.

The Solvency II requirements According to art. 40 of the Solvency II Directive, the managing board has “the collective responsibility for the compliance, by the undertaking concerned, with the laws, regulations and administrative provisions adopted pursuant to this Directive” in the context of the principle of legality. The German legislator does not intend to implement this regulation into the VAG [German Insurance Supervision Act] 2012 but rather to stipulate only the applicability of the BGB [German Civil Code], HGB [German Commercial Code] and AktG [German Stock Corporation Act].⁹² Additionally, as part of the governance system and under arts. 41, para. 1, subpara. 2, and 44 of the Solvency II Directive—or sec. 27 of the VAG [German Insurance Supervision Act] 2012—the managing board must also institute an “effective risk-management system”. Under art. 44, para. 2 of the Solvency II Directive—and in this respect not reflected in sec. 27, para. 3 of the VAG [German Insurance Supervision Act] 2012—this in turn encompasses, inter alia, “the risks to be included in the calculation of the Solvency Capital Requirement as set out in Article 101(4)”. In addition, all insurance undertakings must conduct an ORSA process at regular intervals as part of the risk management system in accordance with art. 45 of the Solvency II Directive or sec. 28 VAG [German Insurance Supervision Act] 2012.⁹³ Part of this process is an assessment of “overall solvency needs” and “compliance, on a continuous basis, with the capital requirements” as laid down in the Solvency Capital Requirement and the Minimum Capital Requirement. In other words, the managing board of an insurance undertaking bears the responsibility of monitoring the solvency of the undertaking and managing it with respect to solvency requirements under supervisory law⁹⁴ as an integral part of the basic governance requirements in Pillar II of the Solvency system.⁹⁵

There are, in addition, numerous detailed requirements within the three key elements of the new solvency system (the rules on own funds, on the Solvency Capital Requirement, and the Minimum Capital Requirement). Meeting these requirements is essentially also the responsibility of the managing board. With respect to the application and use of an internal model, the responsibility of the managing board appeared so important to the European legislator that it was expressly emphasized multiple times, specifically in arts. 116 and 120, para. 3 of the Solvency II Directive, with references to a “responsibility” of the managing board. The Governments Draft of the VAG [German Insurance Supervision Act] implements this in sec. 104 VAG [German Insurance Supervision Act] 2012.

The collective responsibility of the managing board for managing the capital resources of the insurance undertaking With this as background, the management of the capital resources of the insurance undertaking must be viewed as an essential component of responsibility assigned to the managing board in connection with the strategic management of own funds. This has specific consequences for the role of the managing board and its members relating to the solvency of the insurance undertaking. For one thing, the managing board has collective responsibility under corporate law for this important task by virtue of an explicit set of obligations under the Solvency II Directive. This means a minimum level of obligation on the part of each managing board member to work toward upholding and fulfilling the duties incumbent on the entire managing board.⁹⁶ Thus, responsibility for capital resources can no longer be assigned to a single managing board member as a sole departmental responsibility. However, the entire managing board retains management responsibility when it assigns, as a horizontal delegation,⁹⁷ to an individual managing board member from within the entire managing board the preparation, execution and follow-up for decisions made in this area by the managing board as a whole.

To be sure, the solvency of an insurance undertaking is already a core issue of management. However, the Solvency II requirements expand the scope of the management responsibilities at issue. The subject matter of the managing board’s collective responsibility is no longer only the fulfillment of supervisory solvency requirements in the sense of deciding on results. In the future, the entire managing board of an insurance undertaking will also be required to engage in the processes and conditions on which basic solvency-related management decisions are based. For the conception of the managing board’s role with respect to solvency, this switch from solvency management based primarily on results to management based on both process and results according to the principle of collective responsibility is a particularly important caesura brought on by Solvency II.

In meeting this responsibility under Solvency II, however, the danger arises that this independent management of solvency now required of the entire managing board could dissipate into an accumulation of technical processes that is not straightforward or understandable even by the managing board members, accompanied by an ensuing unreflected dependency on it. The pseudo-accuracy of calculations and faith in models underlying Solvency II can compound this situation and likewise diminish the managerial function of the entire managing board, which has an additional significance in the future. The calculation by individual undertakings of their Solvency Capital Requirements based on risk favors the use of the most complex model possible—namely, an internal model.⁹⁸ This also has implications for the solvency-related fitness requirements of managing board members, which are highly significant in the present context.⁹⁹

Capital investment, asset liability management, the internal model, and segment orientation as components of solvency management under the collective responsibility of the managing board of an insurance undertaking

The assignment of solvency management to the collective responsibility of the managing board has specific consequences. To begin with, it means that capital investment is part of the collective responsibility of the managing board. It is the key element on the asset side of the balance sheet. At the same time, capital investment must sufficiently and risk-appropriately reflect the strategy of the insurance undertaking and the resulting obligations on the liabilities side. As vividly expressed in sec. 69, para. 1 of the VAG [German Insurance Supervision Act] 2012 in a rather modified implementation of art. 75, para. 1 of the Solvency II Directive using the term “solvency oversight”,¹⁰⁰ a comparison of “assets and liabilities must be prepared for the purpose of determining current own funds” under such oversight. And technical provisions must be formed—according to art. 76, para. 1 of the Solvency II Directive and similarly sec. 70, para. 1 of the VAG [German Insurance Supervision Act] 2012—“with respect to all of their insurance and reinsurance obligations towards policyholders and beneficiaries”. The capital investments of an insurance undertaking also represent a significant portion of its own funds. Thus, the basic issues as to which capital investments the insurance undertaking holds and how these are adjusted in terms of scope, type, duration, etc. in response to internal and external influences are part of the core area of management that constitutes the responsibility of the entire managing board of an insurance undertaking according to sec. 76 of AktG [German Stock Corporation Act].¹⁰¹ The external influences include in particular the Solvency II requirements on capital resources as well as the coverage capacity of individual investments. The more volatile a capital investment is, the more solvency capital it ties up under supervisory law.¹⁰² And the less it can contribute to covering solvency requirements, the more it adversely impacts, depending on its size, the strategy of the particular insurance undertaking.

However, the assignment of capital investment to the collective responsibility of the managing board of an insurance undertaking, does not necessarily mean that key elements of capital investment cannot continue to be assigned to a department of the managing board under an allocation of responsibilities in the organization. Collective responsibility means, as discussed earlier, only that the full managing board must decide on the critical issues that fall within the respective department, and that each individual member of the managing board shall share the obligation to uphold and fulfill the associated duties. Therefore, should there be a case of liability based on a fundamental defect in a capital investment, no managing board member of an insurance undertaking can argue that one particular member of the managing board was exclusively responsible for the capital investment. Beyond the limits of possible horizontal delegation, capital investment is thus the affair of the entire managing board. Managing board members bear personal responsibility for decisions in connection with their capital investment duties, but they can delegate other elements of these non-delegable duties.¹⁰³ These elements primarily include preparation, implementation, and follow-up work associated with decisions that fall under collective responsibility. Decisions within this area can be ceded to a the sole responsibility of a managing board member at the outset.