Solvency II—An Introduction To Ancillary Own Funds

What are Ancillary Own Funds?

Ancillary own funds (AOF) is a new form of Tier 2 capital for insurers under Solvency II.

AOF can count as Tier 2 capital towards an insurer's Solvency Capital Requirement or any additional capital buffer that may be required by the Prudential Regulation Authority (PRA). It is not eligible to count towards an insurer's Minimum Capital Requirement.

The key distinction between AOF and other Tier 1 or Tier 2 basic own funds (BOF) items is that AOF – although committed – is not paid-up or called-up when issued. Instead, it absorbs losses when it is paid-up or called-up at a future point in time by creating Tier 1 BOF.

What Instruments are Eligible as AOF?

AOF can take various forms – as specified by Article 74 of the Delegated Acts – including:

• unpaid and uncalled ordinary share capital callable on demand;
• unpaid and uncalled initial funds or members' contributions callable on demand;
• unpaid and uncalled preference shares callable on demand;
• a legally binding commitment to subscribe and pay for Tier 1 subordinated notes or loans (or Tier 2 subordinated notes or loans if the AOF is to qualify as Tier 3 capital) on demand;
• letters of credit or guarantees held on trust for the benefit of insurance creditors from certain authorised credit institutions;
• letters of credit or guarantees callable on demand and free from encumbrances;
• any future claims of a mutual or mutual-like association against members by way of a call on demand for supplementary contributions within 12 months; or
• any other legally binding commitment received by an insurer provided that the commitment can be called-up on demand and it is clear of encumbrances.

The common feature of all of these types of AOF instruments is that they must: (i) create Tier 1 BOF capital when paid-up or called-up; and (ii) be callable "on demand".

It is expected that most AOF instruments will take the form of a commitment to subscribe for equity on demand. Although the Solvency II regime permits insurers to raise AOF in the form of letters of credit or guarantees, these are likely to suit those insurance groups where the counter-indemnity owed to the grantor of the letter of credit or guarantee (to repay the grantor if the instrument were to be called) can be provided by an entity outside of the Solvency II-regulated group.

What are the key features of AOF instruments?

As part of the PRA's approval process for AOF, an insurer must submit a cover letter to the PRA explaining the proposed structure of the instrument and providing analysis of various matters as required by the European Commission's Implementing Technical Standards for AOF. These are set out in full in the PRA's application form and include:

• an assessment of the default risk and liquidity position of the counterparty or counterparties (i.e. the party or parties providing the commitment to pay up the Tier 1 BOF capital);
• a description of the range of circumstances in which the insurer might seek to call the AOF, including current expectations as to when the AOF instrument might be called prior to or at the point of non-compliance with the Solvency Capital Requirement or Minimum Capital Requirement;
• analysis that the AOF is callable "on demand" in accordance with EIOPA's guidelines on AOF and clear of encumbrances;
• confirmation that the AOF instrument and any connected transactions with the counterparty or counterparties do not contain any disincentive on or restrain the insurer's ability to call the AOF instrument;
• a description of any features (such as the posting of collateral) that might enhance the recoverability of the AOF;
• analysis of any national law in the relevant jurisdictions of the counterparty or counterparties which may prevent a call being made or satisfied, including in the event of resolution, administration or insolvency proceedings; and
• legal opinions that the AOF instrument is legally valid, binding and enforceable in all relevant jurisdictions of the parties to the contract.

What are the main benefits of AOF?

The main advantages of raising AOF over Tier 1 or Tier 2 BOF items include:

• Cost of capital: the overall cost of committed but unpaid or uncalled capital would normally be lower than paid-up or called-up capital, so being able to meet the Solvency Capital Requirement or any additional capital buffer through AOF would reduce an insurer's overall cost of capital.
• "On demand" flexibility: unlike some other BOF items (such as Tier 1 or Tier 2 subordinated notes or loans), AOF is callable "on demand". This gives an insurer greater flexibility to determine when to call the AOF instrument to create Tier 1 BOF capital. Under Solvency II, Tier 1 or Tier 2 subordinated notes issued to third party investors will be required to have fixed points of principal loss absorption, whereby the notes or loans are converted into equity or written-down upon a breach of a specified solvency capital ratio, and/or interest deferral or cancellation. AOF is, however, callable on demand, so all or part of the AOF may be converted from Tier 2 capital into Tier 1 capital at any time.
• Manage volatility in the Solvency Capital Requirement: given that it has to be capable of being called on demand, AOF can provide a useful tool to manage volatility in the Solvency Capital Requirement, of which at least 50 per cent must be held as Tier 1 BOF, and an insurer's other BOF items. Having committed but uncalled Tier 1 BOF that can be accessed on short notice could prove advantageous to smooth any such volatility, particularly before financial or regulatory reporting periods.
• Intra-group or shareholder-led capital solution: AOF capital is most likely to be attractive to insurance groups seeking an intra-group alternative to paid-up capital. Plain vanilla structures, whereby contingent equity is committed by a parent or sister company, are likely to be the most common structures in the early stages of the new Solvency II regime. However, AOF could be structured in a more complex way to enable a third party investor, such as an existing minority shareholder or a prospective new shareholder, to subscribe for equity or subordinated debt not just on demand but at predetermined solvency trigger points.

Comment

The PRA process for assessing AOF applications has not yet been tested, as the first applications will be formally submitted in the coming weeks and the PRA (and before it, the FSA) has not previously had to consider whether uncalled capital can count towards an insurer's capital requirements. The PRA will have three months to assess applications (or up to six months in "exceptional circumstances"), but the PRA is likely to be keen to ensure that the position it takes in relation to any particular application is consistent with the position that would be taken by other national supervisors: it would undermine one of the key purposes of Solvency II if capital treatment depended on which supervisor was involved.