Definition and Holders of Key Functions
(1)
Johannes Gutenberg University, Mainz, Germany
Abstract
This chapter takes up the four key functions established in the Solvency II Directive. In this vein, the significance of the key functions is highlighted first. Then follows the analysis of the terms “key function” and “key function holders”, terms undefined in the Solvency II Directive. The next step points out the distinctions among key function holders and their subordinate staff members. A part of this breakdown is to examine in practice who exercises which function in an insurance undertaking. The chapter wraps up by looking at whether key functions are performed in a centralized or decentralized organization.
First published as “Begriff und Inhaber der Schlüsselfunktionen nach Solvency II und VAG 2012” [in English: Concept and Holders of Key Functions under Solvency II and the VAG 2012 [German Insurance Supervision Act 2012]], VersR (2012), 933 ff. Note to the reader: Eventually, the VAG 2012 did not take effect, but was postponed. Therefore, in the following text, VAG 2012 must be read as “2012 Government’s Draft of a Tenth Act Amending the German Insurance Supervision Act”.
7.1 Introduction
The term “key function” has a generally positive connotation. It suggests responsibility and importance. But it has hardly seen use as a legal term.1 This will change when the rules of Solvency II and their implementation in the new VAG 2012 [German Insurance Supervision Act 2012]2 take effect. This is so because the term “key function” is the starting point for numerous rules of the insurance supervisory regime. These are directed at both insurance and reinsurance undertaking3 and their staff members in certain roles as well as at the insurance supervisory authorities. Also at issue are important elements in the governance of insurance undertakings and their monitoring by supervisory authorities.
Against this background, the present article aims first to clarify the term “key function” under European law and the employment of that term in the German insurance supervisory regime (below, 7.2). The discussion then turns to the question of which staff members are in key functions, and in what capacity (below, 7.3). Numerous other questions emerge from this concerning, for example, the requirements to ensure the expertise of such persons and that they are fit and proper for this role, their compensation, their duties of disclosure and notification with respect to the supervisory authority or the public, and whether the supervisory authority can recall certain persons or prohibit them to exercise the relevant duties. These questions will be the topic of a subsequent article.4 Excluded or only touched upon as the subject matter of either essay, however, are other issues associated with the topic of key functions, particularly the relationship of individual key functions to one another,5 the independence and segregation of key functions,6 and the effects of outsourcing on key functions.7
7.2 The Term “Key Function”
7.2.1 The Key Functions
7.2.1.1 Solvency II
At the first regulatory level of the new European insurance supervisory regime, the Solvency II Directive,8 the term “key function” is initially found in Recital 33. In this provision, the European issuer of the Directive establishes that certain functions within an undertaking “are considered to be key functions”.9 In the view of the issuer, these are “consequently also important and critical functions”. Recital 33 of the Solvency II Directive further clarifies which functions are key functions under the law: “The functions included in the system of governance are considered to be key functions”. It thus refers to the four functions specified in art. 13, no. 29 of the Solvency II Directive, which are set forth as mandatory in art. 41 ff. of the Solvency II Directive concerning the “system of governance” for all insurance undertakings. The four functions are the risk-management function, the compliance function, the internal audit function, and the actuarial function.
7.2.1.2 VAG 2012 [German Insurance Supervision Act 2012]
Sec. 8 no. 11 of the VAG 2012 [German Insurance Supervision Act 2012] includes the four governance functions as found in art. 13, no. 29 of the Solvency II Directive. However, the overarching term here is not “governance”, but “business organization”. Also absent in the implementation is a section equivalent to Recital 33 of the Solvency II Directive. Thus, the VAG 2012 [German Insurance Supervision Act 2012] does not designate the governance functions as key functions. Given the primacy of the European law and the provisions found there, it may be said that this omission is essentially harmless. However, if the functions of the business organization are not coupled with the term “key functions”, the regulatory system becomes needlessly intransparent for those who apply the law but are not familiar with the European insurance supervisory regime. Furthermore and most importantly, the legislator will be passing up the opportunity to mirror the central terminology of the European insurance supervisory regime in the national insurance supervisory regime at what is called the “fourth regulatory level” although this would be in the interest of a uniform classification. This means that an essential new term will already be missing in the definitional provision of sec. 8, no. 11 of the new VAG 2012 [German Insurance Supervision Act 2012], even though numerous later provisions within the VAG [German Insurance Supervision Act], are tied to it.
Hence, VAG 2012 [German Insurance Supervision Act 2012] makes reference to the key functions in sec. 8 no. 11 only as follows:
the business organization includes the risk-management function, the compliance function, the internal audit function, and the actuarial function.
The rules for each key function follow, with the risk management function—to further semantic confusion, however, in its terminological use of “risk controlling function” deviating from European law—in sec. 27, para. 5 of the VAG 2012 [German Insurance Supervision Act 2012], the compliance function in sec. 29, paras. 1 and 2 of the VAG 2012 [German Insurance Supervision Act 2012], the internal audit function in sec. 30 of the VAG 2012 [German Insurance Supervision Act 2012], and the actuarial function in sec. 31 of the VAG 2012 [German Insurance Supervision Act 2012].
7.2.2 Terminological Dual-Tracking and the Irrelevance of the Difference Between “Key Function” and “Key Task”
7.2.2.1 Solvency II
In the German version of the Solvency II Directive, the term “Schlüsselaufgabe” [in English: key task] is seen in addition to the term “Schlüsselfunktion” [in English: key function]. The German “Schlüsselaufgabe” is found only in art. 42, paras. 1 and 2 of the Directive, where it is rendered as “key function” in the English language version. In para. 1, it concerns the fit-and-proper requirements for “all persons who effectively run the undertaking or have other key functions”. In para. 2 however, it refers to the duty of notice on the part of the insurance undertaking with respect to the supervisory authority and applies to “any changes to the identity of the persons who effectively run the undertaking or are responsible for other key functions”.
In numerous other official languages of the Solvency II Directive—such as the English, French, and Dutch versions—this terminological dual-tracking does not occur. In these versions, a single term—“key function” in the English—is used throughout, including in art. 42, paras. 1 and 2 of the Directive. While the Solvency II Directive does see dual-track terminological structures here and there—for example, in the Spanish and Italian language versions—they differ from those found in the German version. Specifically, in these cases, the Directive uses the term “fundamental function” (English equivalent) in both art. 42 as well as art. 44 of the Solvency II Directive while choosing a different term in Recitals 33 through 35 of the Directive.
Under the European methodology, as established in the jurisprudence of the European Court of Justice, the interpretation of secondary law, which starts with the wording, must take all language versions into consideration. Majority rule does not apply here. Instead, in cases where language divergence could result in divergence of content, an interpretation according to the context and purpose of the rule is required.10 In the present context, there has been no apparent divergence in content. In the Solvency II Directive, some language versions proceed exclusively from the term “key function” in the relevant Recitals 33 f. and art. 42, paras. 1, 2 as well as 44 para. 1 subpara. 2 of the Directive—each in the German conception—and thus feature a terminological difference between the recitals and articles or—as in the German language version—between the recitals and art. 44 of the Directive on one hand and art. 42 of the Directive on the other. Ultimately, the broader picture that emerges is quite clear. In the Solvency II Directive, for these recitals and the relevant articles the matter at hand is not the diffusion of different content through different terminology. Rather, it is concerned with emphasizing specific functions. It achieves this emphasis in the majority of individual language versions with systematic uniformity and consistency. But for those language versions that deviate and incorporate linguistic dual-tracking, their apparent arbitrariness does not detract from the sole objective of emphasizing specific functions. It can therefore be presumed, in summary, that the terminological distinction between “key function” and “key task” in the German language version of the Solvency II Directive serves no larger contextual significance other than emphasizing the special importance of the respective function.
This equivalence of key function and key task provided by the European law is confirmed in provisions at Levels 2 and 3 of the Solvency system. The DVO11 uses the term “key function” exclusively in five different articles and regulatory statements. The same can be seen in the very frequent use of only this term in the draft of the CEIOPS Consultation Paper, Draft proposal for Level 3 Guidelines on the System of Governance of December 2010.12 Under art. 71, para. 2, sent. 2 of the Solvency II Directive, the supervisory authorities of the Member States are required to “take [these guidelines] duly into account”. But in sec. 324, para. 1, sent. 2 of the VAG 2012 [German Insurance Supervision Act 2012], the restriction imposed by the word “duly” is omitted.13
7.2.2.2 VAG 2012 [German Insurance Supervision Act 2012]
Sec. 25 VAG 2012 [German Insurance Supervision Act 2012], which is the provision concerned with the expertise and personal qualifications of certain representatives and staff members of the undertaking based on art. 42 of the Solvency II Directive, likewise refers to persons who effectively run the insurance undertaking “or perform other key tasks”. In this respect, sec. 25, para. 1, sent. 1 of the VAG 2012 [German Insurance Supervision Act 2012] follows the wording in the requirement of art. 42 of the Solvency II Directive. Unlike the Solvency II Directive, however, the VAG [German Insurance Supervision Act] draft immediately obscures the difference between key function and key task in the German language version of the Solvency II Directive again. This transpires because, according to the Statement of Reasons for sec. 25 of the VAG 2012 [German Insurance Supervision Act 2012], “the four functions specified in this paragraph (the risk-controlling function, compliance function, actuarial function, internal audit), at a minimum, are considered to be other key tasks”.14
This means that, while according to the German language version of the Solvency II Directive, the use of the different terms “key function” and “key task” is not particularly necessary, the VAG [German Insurance Supervision Act] draft asserts that the key functions of the Solvency II Directive “are considered” key tasks. Finding a reason for this approach becomes just as difficult as discerning a legally sound system in this sort of labyrinthine national regulation. All the same, “function” has a prior definition in sec. 8, no. 11 of the VAG 2012 [German Insurance Supervision Act 2012] as “an internal capacity within the business organization for the assumption of practical tasks”. According to the Statement of Reasons for sec. 25 of the VAG 2012 [German Insurance Supervision Act 2012], then, the functions should themselves be considered key tasks. Even using a generous standard for the semantics of legislative bases, the addressee of the legal rule could expect from the implementing German legislator, in view of the already convoluted terminology in the Directive’s provisions, consistency between the content of the law, namely, function as the capacity to assume a task, and the justification for the law, namely, function as task. Indeed, it should be presumed that Recital 33 of Solvency II Directive has some influence on the law’s statement of reasons. But according to the Recital, the governance functions “are considered” to be “key functions”. This coherent statement runs counter to the Statement of Reasons for sec. 25 of the VAG 2012 [German Insurance Supervision Act 2012] as it concerns substitution of the term “key function” with “key task”. Because of the primacy of the European law, however, the only relevant terminology and content from a legal standpoint are found exclusively in the three levels of Solvency II. This ultimately leads us to the equivalence of the terms “key function” and “key task”, which has already been established.15
7.2.3 The Term “Key Functions”: Exhaustive or Open?
The Solvency II Directive provides for four governance functions as key functions.16 Numerous legal questions arise when a function is classified as a key function.17 Thus, from a legal point of view, under the sub heading of “the term of key function” lies the question of whether the term is exhaustively defined by the European insurance supervisory regime as the four governance functions or remains open to other applications. This is so because only in the latter case could key functions be expanded by national insurance supervisory law.
The Statement of Reasons for the VAG 2012 [German Insurance Supervision Act 2012] readily assumes but only indirectly states that the term “key function” is open and that application of the term is not exhausted with respect to content by the four governance functions. It offers the following on this point:
The four functions specified in this paragraph (the risk-controlling function, compliance function, actuarial function, internal audit), at a minimum, are considered to be other key tasks. However, depending on the circumstances of the respective undertaking, additional areas can be viewed as key tasks if these have considerable importance to the business operations of the undertaking.18
Based, then, on the equivalence previously discussed of the four key functions and the key tasks of the VAG 2012 [German Insurance Supervision Act 2012],19 the catalog of key functions would not be exhaustive. On the other hand, all the Solvency II rules connected with the term “key function” and with the presence of key tasks would necessarily apply to any additional key functions or key tasks under the VAG 2012 [German Insurance Supervision Act 2012]. The criteria—which are entirely undefined—solely relevant to such expansion and its validity should, according to the Statement of Reasons for the VAG [German Insurance Supervision Act] draft, be the “considerable importance” of an “area” of an insurance undertaking “to business operations” according to “the circumstances of the respective undertaking”.
The question then arises as to whether the Solvency II Directive itself has an open or closed conception of the key functions. The starting point for answering this question is Recital 33 of the Solvency II Directive. In the various language versions the Directive, the Recital consistently restricts the designation of key function to the four governance functions. There is nothing to indicate that additional key functions are possible. This is also true with respect to use of the term “key function” in the very text of the Directive, where only the governance functions and not core operating functions, of an insurance undertaking are counted as the key functions. Recitals 98 f. and the relevant articles of the DVO lead to the same conclusion. At both Level 1 and Level 2, the phrase “persons who effectively run the undertaking or have other key functions”20 is found repeatedly. But nowhere do the texts suggest that there could be or even needs to be any additional key functions in an insurance undertaking, nor do they allude to which key functions those might be. The phrase is meant only to convey that key functions have a particularly significant role. This is the only interpretation of the phrase that is consistent with the special, legally far-reaching rules imposed on them.21
The notion that other key functions may exist beyond the four governance functions, is found only at Level 3 in the explanations to the Governance Guidelines.22 It is found in the following text in the introduction:
Persons having key functions include all persons performing tasks related to a key function. At least the functions included in the system of governance, risk management, compliance, actuarial and internal audit, are considered to be key functions and consequently also important and critical functions.
Thus the use of the words “at least” in the Statement of Reasons for sec. 25 of the VAG 2012 [German Insurance Supervision Act 2012] has an equivalent in the Solvency system only at Level 3, namely in the words “at least” in the Level 3 Governance Guidelines. In the explanation to Guideline 14, it is further presumed that insurance undertakings notify the supervisory authority as to which functions are deemed key functions, and on what basis.23
But nothing is yet indicated about the legal effect with respect to the more basic question. While, according to the jurisprudence of the European Court of Justice, Level 2 rules may indeed go beyond Level 1 provisions,24 such a relationship does not apply between the essentially non-binding Level 3 guidelines and the regulations of Levels 1 and 2. In terms of timing, the Guidelines were created prior to the DVO draft. And they are non-binding.25 To view it otherwise would legitimize wide-ranging requirements on insurance undertakings that involve supervisory intervention26 into basic rights without a legal basis at Level 1 or 2 simply as a result of Level 3 Guidelines. The CEIOPS Governance Guidelines—for example, in Guideline 527—extend the mandate of independence under art. 41, para. 1 of the Solvency II Directive and art. 258 SG6 of the DVO to all “key functions”. If the definition of “key function” under the Guidelines were simultaneously open, it could no longer be the basis for insurance supervision in accordance with the rule of law by the principle of legal certainty in the supervision of legality under art. 34, para. 1 and art. 36 of the Solvency II Directive. Intensive supervisory monitoring, with the potential for severe sanctions, of persons and activities in additional key functions, not established by law, that exist under entirely undefined criteria would mean a step backward to the earlier general supervision according to the principles of abusiveness, which is no longer permissible28 under Solvency II. In the end, even the BaFin [German Federal Financial Supervisory Authority] would designate individual business functions as key functions, thereby determining their own scope of supervision.
Furthermore, there is this: The provisions of the Solvency II Directive, except where the numerous rights of election afforded to the Member States and where only minimum standards are set,29 lean toward full harmonization.30 Any deviation from the term “key function” as it is understood in the Solvency II Directive by the insurance supervisory regime of Member States is no more provided for in the Directive than a Member State’s right of election in relation to it. Regardless of the CEIOPS Governance Guidelines, the German legislator cannot expand the scope of sec. 25 of the VAG 2012 [German Insurance Supervision Act 2012] to the effect that “additional areas […] of considerable importance” aside from the four governance functions must be viewed as key functions within the meaning of the insurance supervisory regime. The authors of the Statement of Reasons for sec. 25 of the VAG 2012 [German Insurance Supervision Act 2012] are apparently led astray by the word “other”. This is evident in the statement that the four governance functions, at a minimum, should be considered as “other tasks”. The statement completely misconstrues the telos of the phrase “persons who effectively run the undertaking or have other key functions”, which was discussed previously in the article. Specifically, the phrase is meant to emphasize the significance of other key functions, meaning the four governance functions, in relation to the—staying with the terminology—key function of effectively running the undertaking. It is not intended to represent an opening or invitation within the term “key functions” to include other functions in the undertaking as key functions. Therefore, regardless of the undertaking’s individual hierarchical structure, the heads of any legitimately or effectively prominent business function at the undertaking, other than the governance functions in insurance undertakings, are never, in this capacity, key function holders within the meaning of the insurance supervisory regime.31 This applies, for example, to the actuary, the head of the legal department, the director of the department for prevention and control of money laundering as well as senior staff in the areas of investment, data security, capital investment, accounting, marketing/communications and IT.
7.3 The Key Function Holders and Their Subordinate Staff Members in Key Functions
7.3.1 The Solvency II System
The Solvency II Directive reveals a surprising multiplicity of terms in the areas that deal with persons engaged in key functions. The German language version speaks of “Wahrnehmen” (Recital 34), “Verantwortlichsein” (art. 42, para. 2), and “Innehaben” (Recitals 34, 35; art. 26, para. 3 and 42, para. 1 and 44, para. 1 subpara. 2). The English language version recognizes the terms “perform” (Recital 34), “holder” (Recital 34), “responsible” (art. 42, para. 2) and “have” (Recital 35; art. 26 para. 3 and 42, para. 1 and 44, para. 1 subpara. 2). The French version uses “exercent” (Recital 34), “titulaire” (Recital 34), “ont” (Recital 35), “ocupent” (art. 26, para. 3 and 42, para. 1 and 44, para. 1 subpara. 2) and “assument” (art. 42, para. 2). The Spanish language version has the terms “ejerzan” (Recital 34, art. 44, para. 1 subpara. 2), “titulares” (Recital 34), “empeñen” (Recital 35; art. 26 para. 3 and 42, para. 1) and “responsables” (art. 42, para. 2). In other official languages, the same picture emerges of inconsistent use across a great multiplicity of terms—the Italian language version alone recognizes five different words for the activities under discussion, appearing across just six rules.
The DVO is no different. It generally contains the term “have” (Recital 99; arts. 251 SG3, 263 SG11, para. 1, and 285, para. 2 a and b), but it also uses the words “responsible” (Recital 98 sent. 1 and art. 297 SRS4, para. 2 a), “perform” (art. 258 SG6, paras. 3 and 4)32 and “holders” (art. 265 SG13, para. 1 c).
Faced with this multiplicity of terms, only the wording of the Level 1 and 2 texts can only give first hints for making further distinctions in a system of diverse legal requirements. It is then apparent from the start that the Directive and the DVO intend to distinguish between persons who “hold” a key function and are “responsible” for it and those who “perform” tasks that are part of a key function. This linguistic distinction, however, is not strictly respected in the text of the rules and it becomes further blurred by the excessive use of additional words that are somewhat synonymous.
In light of these circumstances, the definition of persons who are legally included in the Solvency II Directive and the DVO in various ways is in need of additional systematic and teleological clarity. The starting point is the substantive differences seen in the Solvency II provisions beyond simply the terminology.
7.3.2 The Equalization of Key Function Holders and Persons Who Effectively Run the Undertaking
7.3.2.1 The Normative Point of Departure
The foundation for this systematic and teleological approach is the equalization of persons who hold “other” key functions with “persons who effectively run the undertaking”. This equalization is evident in Recital 35 and in art. 26, para. 3 and 42, para. 1 and 42, para. 2 as well as 44, para. 1, subpara. 2 of the Solvency II Directive, and also in Recital 98, sent. 1 and 99, art. 251 SG3, 263 SG11, para. 1, 265 SG13, para. 1 c as well as 285 PDS4, para. 2 a and b of the DVO. The Solvency II Directive places special requirements on this type of management personnel because their actual management responsibilities with or even—and herein lies the special significance of rule—without their formal membership in management make them distinct in the risk-oriented nature of the Solvency II system.33 In addition to management, meaning the managing board of an insurance undertaking operating under a dual structure, there are both general agents in the subsidiary offices of insurance undertakings34—at least according to the VAG 2012 [German Insurance Supervision Act 2012]—as well as the few de facto members of management body as laid down in company law.35 At issue is whether and which of the staff members subordinate to management are included in this group of persons with special significance.
7.3.2.2 The System, Telos and Scope of Equalization
The word “other” preceding “key functions” in the text of the Solvency II rules is intended to establish equalization with the responsibilities assumed for the “effective running of the business”. This is so because only through this word is the responsibility associated with a key function effectively elevated to the level of management of the undertaking, and thus it confers the necessary importance required for such equalization.36 It is not, on the other hand, intended to expand the circle of key function holders. This conclusion can be drawn directly from the legal consequences associated with such classification. The far-ranging fit-and-proper requirements of Solvency II37 can be justified only if a responsible person in the undertaking holds a position so distinct that it warrants essentially the same high requirements imposed on members of the managing board. This is consistently expressed in the Solvency II system at Levels 1 and 2 in that it distinguishes the management generally understood to be a core function in an insurance undertaking38 from “other key functions” which—apart from the activities of supervisory board members, to be addressed presently—are understood to be the four governance functions only.39 So called senior management, then, is also not part of this level.40
7.3.2.3 The Special Question of Equalization of Supervisory Board Members
While the activities in key functions other than management exhaustively restrict the addressees of the legislation and demarcate them from levels below, the question remains—at least in the dual governance system—as whether the supervisory board overseeing the managing board forms another key function in this sense. Even before the submission of the draft of the DVO for the Solvency II Directive and draft of the VAG 2012 [German Insurance Supervision Act 2012], some of the literature41 had been including supervisory board members as key function holders, making reference to earlier papers from CEIOPS.42 But this runs counter to both the wording and the system of the Solvency II Directive. This is so because arts. 248 and 257 extend the fit-and-proper requirements only to members of supervisory boards for undertakings that are members of a group or for insurance holding companies.43 However, art. 263 SG 11 para. 3 DVO, which was published only afterwards, contained not only—as in art. 249, no. 1 c of the DVO—a reference to the usual triad of “administrative body”, “supervisory body”, and “management body”,44 but also the two management body activities, “managed” and “overseen”. This could be misunderstood as meaning that the rule intends to view even supervisory board members as being encompassed by the Solvency II Directive in art. 42, i.e. the underlying rule to be concretized.45
However, such a far-reaching question as the inclusion of all supervisory board members in fit-and-proper supervision under European law is not posed by a single word in the subject matter of the DVO. Rather, the choice of words can be explained quite simply by looking at either the monistic system of corporate entities in some Member States or, in the dual system, at the activities of the managing board that encompass organizational and supervisory duties in a company.46 The new consultation paper of European Banking Authority for the fit-and-proper supervision of lending institutions distinguishes clearly between supervisory board members, managing board members and key function holders.47