Substantive Changes to EU Solvency II Remuneration Requirements on the Horizon

On July 25, 2019, the European Insurance and Occupational Pensions Authority (EIOPA) published a consultation paper, “Draft Opinion on the Supervision of Remuneration Principles in the Insurance and Reinsurance Sector” (Draft Opinion). The Draft Opinion provides guidance on the application of the existing Solvency II remuneration requirements.

If finalized in its current form, the Draft Opinion will require insurers and reinsurers subject to Solvency II (Solvency II firms) to review and, in many cases, substantially overhaul their existing remuneration policies.

The consultation period for comments on the proposals in the Draft Opinion is open until September 30, 2019.

BACKGROUND AND CURRENT POSITION

Solvency II firms are required to have a remuneration policy covering certain senior staff responsible for those firms (Solvency II Staff), which must comply with principles set out in Article 275 of the Solvency II Regulations¹ (Article 275). 

• an expectation of a suitable balance of fixed and variable components of remuneration 
• the deferral of a “substantial portion” of variable remuneration for not less than three years
• the application of downward adjustment to variable remuneration for exposure to current and future risks 

Unlike the remuneration requirements in the banking and investment management sectors, the Article 275 principles are not particularly detailed or prescriptive and are open to a reasonable scope for interpretation by both national regulators and Solvency II firms.

In the UK, the Prudential Regulation Authority (PRA) published a supervisory statement (SS) giving guidance as to its expectations².  The guidance set out details as to the PRA’s view on what constitutes variable remuneration, how vesting should apply under deferral arrangements and also the PRA’s view that the “substantial portion” of variable remuneration that must be deferred for a minimum of three years was “very unlikely” to be less than 40 percent.

The PRA noted that the principle of proportionality contained within Article 275 limited the full application of its expectations in the SS to significant firms only (Category 1 and 2 PRA-regulated firms – being many of the larger insurers and reinsurers) and that it considered that for smaller insurers (such as those that operate in one locality or niche market) to seek to meet the expectations of the SS would have a disproportionate cost impact on these firms. However, the PRA also made clear that the application of proportionality did not equate to smaller firms being able to disapply the requirements of Article 275. 

Significantly, the PRA guidance noted that it had sought “to limit the potential for outcomes that are disproportionately different across sectors” and made reference to the PRA and Financial Conduct Authority guidance in respect of banking and asset management entities that disapplies the deferral requirements if an individual has total remuneration of no more than £500,000 and has been awarded variable remuneration of no more than 33 percent of their total remuneration. 

EIOPA DRAFT OPINION 

The Draft Opinion acknowledges that the principles in Article 275 are high-level and “leave considerable discretion to the undertakings and supervisory authorities” and that, as a result, “divergent practices have emerged across Europe.” It states that it is intended to give guidance to national supervisory authorities on “how to challenge the application of the principles.”

Although it notes that it “is not EIOPA’s intention to add requirements or to create administrative burden,” the draft guidance adds far greater detail to the existing principles in Article 275 and, from a UK perspective, in places, diverges from and is far more prescriptive than the existing PRA guidance.

KEY CHANGES FROM THE DRAFT OPINION  

The Draft Opinion reflects a closer convergence with the remuneration regimes applicable to the banking and investment management sectors.

Key points: 

• €50,000 threshold: EIOPA’s expectation is that the remuneration principles will be applied to Solvency II Staff whose annual variable remuneration exceeds €50,000 and represents more than one-quarter of that staff member’s total annual remuneration. Although this is consistent with the upcoming threshold change for investment management firms  (albeit that those requirements may be disapplied in certain circumstances), this is far lower than the thresholds (total remuneration of £500,000 and more than 33 percent of total remuneration) in the PRA’s existing guidance and represents a significant expansion of the application of the requirements.
• 1:1 Ratio of fixed to variable remuneration: Supervisory authorities will be expected to engage with and investigate the balance of a Solvency II firm’s remuneration policy if the ratio of its Solvency II Staff’s remuneration exceeds a 1:1 ratio, fixed to variable remuneration. This indicates that the current practice by some Solvency II firms of paying substantially more than 100 percent bonuses may now come under scrutiny by national regulators. In the UK, for example, this is an area not explicitly covered by the PRA’s SS and could lead to a need to change remuneration practices or explain any divergence from a greater than 1:1 ratio. 
• Definition of “substantial proportion”: Consistent with the PRA’s SS, the deferral of 40 percent of variable remuneration is considered a substantial portion of variable remuneration, but the relevant supervisory authority will be expected to use its judgement on whether the proportion should be higher or deferral period longer. There is also a recommendation that a higher deferral rate than 40 percent be applied in cases of a particularly high variable remuneration. The guidance gives the example of a case of a ratio higher than 1:1, fixed to variable. Again, this will mean that some Solvency II firms that pay greater than 100 percent bonuses to certain senior staff may now need to require such staff to defer a greater proportion of that bonus. 
• Assessment of performance: Article 275 requires that financial and nonfinancial criteria be taken into account when assessing an individual’s performance.The guidance sets out an expectation that the assessment be set in a “multi-year framework” with the entire decision-making process being “clear and predetermined, appropriately explained and documented.”

The guidance notes that

• “financial (quantitative) criteria” should cover “a period which is long enough to capture the risk taken by staff members and should be risk adjusted”
• “non-financial (qualitative) criteria” should “contribute to the creation of value for the undertaking,” giving examples including compliance with regulations, achievement of strategic goals (such as “Environmental, Social and Governance criteria, ethical aspects,” behaviour, consumer satisfaction and adherence to the undertakings’ risk management policy 

The Draft Opinion states that assessment criteria should be appropriately balanced between financial and nonfinancial criteria, specifically noting that where the criteria is 80 percent financial and 20 percent nonfinancial the firm’s relevant supervisory authority may conclude that it is not appropriately balanced. Criteria of this nature may well be included in Solvency II firms’ existing remuneration structures, but the guidance is far more prescriptive than that in Article 275 or the PRA’s SS, and firms will need to analyze whether an overhaul of their assessment criteria and the balance between financial and nonfinancial aspects is required. 

• Composition of the variable remuneration:

• EIOPA expects that Solvency II Staff should have 50 percent of variable remuneration in shares, equivalent ownership or share-linked instruments if proportionate and feasible. These instruments are expected to be subject to “an appropriate retention policy designed to align incentives with the longer-term interests” of the Solvency II firm. This applies to both deferred and nondeferred portions of the variable remuneration component. The guidance notes that a supervisory authority may conclude following a risk-based and proportionate assessment that “the ‘composition requirement’ should be applied in a simpler and less burdensome manner” for certain Solvency II firms. The guidance also states that “appropriate (financial) instruments might not be available to a considerable group of undertakings due to their legal form” and that “such undertakings are encouraged to consider developing equivalent non-cash instruments.” (This new guidance represents a significant tightening in expectations for the form of variable remuneration with, in the UK, current guidance not expressly precluding payments entirely in cash. It brings the insurance sector more closely in line with current expectations in the banking and investment management sectors).

TIMING

The Draft Opinion states that EIOPA will start monitoring its application by supervisory authorities two years after its publication. Given the date that the consultation closes (September 30, 2019) and the date that the UK is currently due to leave the European Union (EU), the UK will likely have left before the Draft Opinion becomes effective in respect of the application by the PRA of Solvency II. However, depending on the UK government’s approach to the continued alignment of the UK with EU financial services regulatory regime, it is likely that the PRA will apply the guidance in the Draft Opinion.

PRACTICAL IMPLICATIONS 

The guidance set out in the Draft Opinion will require Solvency II firms to review and, in many cases, substantially overhaul their existing remuneration policy practices. Whilst EIOPA’s monitoring of the application of the final form of the Draft Opinion by national regulators will commence in 2021 or 2022, Solvency II firms have an opportunity to respond to the consultation and potentially influence the final form of the Draft Opinion. However, given the effort in the EU more closely to align remuneration practices across sectors, and the Draft Opinion indicating greater consistency with current and upcoming approaches in the banking and investment management sectors, it is perhaps unlikely that the final form of EIOPA’s opinion will reflect significant changes to the current draft.

¹ Commission Delegated Regulation (EU) 2015/35

² PRA Supervisory Statement SS10/16, Solvency II: Remuneration requirements (updated in July 2018)

³ https://www.sidley.com/en/insights/newsupdates/2019/04/new-eu-investment-firm-prudential-regime