Since the implementation of the European supervisory regime Solvency II in 2016 and the transposition of the Directive on the activities and supervision of institutions for occupational retirement provision (IORP II) into national law, the proportionality principle (see info box "Principle of proportionality") has played a central role in regulation and supervision.

The rationale is that the more principle-based approach of Solvency II and the IORP II Directive (see info box “Principle-based approach and rule-based requirements") opens up new room for manoeuvre not only for insurance undertakings and institutions for occupational retirement provision (IORPs), but also for BaFin. The principle of proportionality makes it possible to implement principle-based supervisory requirements in a flexible way and in line with the risk situation of the insurance undertaking concerned.

Although (or because) this type of regulation offers room for manoeuvre, the proportionality principle remains a critical issue for many insurers and IORPs. This is mostly due to the fact that its application is not easy to understand in practice. Since a key aspect of principle-based supervision is that there are no ready-made solutions or checklists, company-specific approaches must be used to fill in the supervisory framework. In contrast to the old supervisory regimes, there is therefore no uniform solution that would apply equally to all supervised undertakings. Rather, the individual circumstances must be examined in each case in order to find tailor-made solutions that are appropriate to the undertaking’s risk situation. At the beginning, this puts an extra burden on undertakings and creates uncertainty, but this can be removed by risk-sensitive internal concepts and communication with the supervisory authority. The additional effort is worthwhile if the undertakings concerned are then able to implement a number of tailor-made solutions.

It is particularly important for small and medium-sized insurance undertakings to tackle the proportionality principle in a pro-active manner: Solvency II often poses a challenge for them, because the regulatory framework regulates certain areas more intensively and requirements are more demanding in terms of content than under Solvency I. The initial implementation in particular placed a great burden on the undertakings and put a strain on their capacity. For these insurance undertakings, however, the proportionality principle is a necessary corrective and all the more important if they want to reduce their burden under Solvency II.

Initial experience in dealing with the principle under Solvency II

Surveys by industry associations show that the majority of insurance undertakings are currently dissatisfied with how BaFin applies the proportionality principle and see a need for improvement. Criticism focuses, among other things, on the extensive reporting requirements under Solvency II and the – from the industry’s perspective – unsatisfactory solution applied to exempt undertakings from their quarterly reporting obligations. The undertakings mainly refer to cost-benefit considerations when they complain about the lack of proportionality, whereas from the supervisory point of view it is actually a matter of ensuring a risk-based approach. Lower risks do allow the requirements to be implemented in ways that are less complex and therefore less burdensome. However, this does not mean that the principle of proportionality could turn the Solvency II regime into a free ride. Due to the significantly increased overall requirements under Solvency II, even undertakings whose risk situation justifies an implementation that requires only a minimum of effort will inevitably face higher costs than was the case under the old Solvency I regime.

Despite all criticism, experience in dealing with the principle of proportionality shows that, together, supervisors, industry representatives and undertakings can work out solutions.

Capital adequacy requirements: pillar 1 of Solvency II

The market-consistent valuation of technical provisions provided for under Solvency II can pose a major challenge for undertakings. This applies in particular to contracts with long-term guarantees, which are typical in life and health insurance. The relevant legislation does not prescribe any method for calculating the provisions. Rather, the undertakings themselves must choose a method that reflects the risks arising from their contracts. This is in keeping with the nature of proportionality: the undertaking may use a simplified calculation method as long as it still adequately captures the risks arising from the undertaking’s obligations. This is very important in practice. As an example, many health insurers use methods for the valuation of their provisions that are much less complex than in life insurance. This is possible because the specific risks arising from health insurance obligations can be described using a simpler system of assumptions.

The calculation of the SCR can also be very complex. For undertakings that do not use an internal model, legislation provides for a standardised calculation using the standard formula. Naturally, the scope for applying the principle of proportionality is smaller here. In order to facilitate the calculation of the standard formula, simplifications are permitted for certain risk modules. In practice, these are used in particular to calculate the counterparty default risk. Simplified calculations for underwriting risks in life and health insurance, on the other hand, are used relatively infrequently, mainly because they are rarely needed. As part of the current review of the SCR standard formula calculation, BaFin has successfully advocated for the inclusion of further simplifications. These usefully extend the existing simplifications and refer, for example, to the application of the look-through principle in the calculation of market risks and catastrophe risks. This is a good starting point, but it should not end there. BaFin therefore welcomes the fact that, in the Solvency II review, the European Insurance and Occupational Pensions Authority (EIOPA) is examining how the complexity of the standard formula calculation can be further reduced.

In BaFin’s opinion, however, neither the simplifications that are currently permitted nor those that will be possible in the future can be allowed to result in methods that no longer adequately reflect the undertaking’s risks. Sensibly, the legislation therefore makes the application of simplifications subject to certain conditions. Discussions with the industry have repeatedly shown that the undertakings need more specific criteria defining the scope available to them. In order to support the application of the proportionality principle in practice, BaFin published an interpretative decision in November 2018. This contains clarifications on how undertakings should verify that the methods used to calculate their provisions are appropriate. Among other things, the interpretative decision addresses the term "error", which plays a central role in assessing the appropriateness of the method.

Governance requirements: pillar 2 of Solvency II

Many of the rules on governance are principle-based, and as a result the principle of proportionality is often applicable.

An issue which keeps recurring in discussions with the industry is that of the written policies provided for under Solvency II and further specified in requirements from BaFin.¹ Many undertakings ask that these requirements be streamlined. They argue that the requirements unnecessarily tighten the policies and lead to excessive bureaucracy.

The particular importance of the written policies is stems from the fact that undertakings define in them the structure of their system of governance; they are thus a means for self-regulation. The purpose of the policies is to establish processes and procedures and to transfer and define tasks, powers, responsibilities and competences. The policies ensure that managers and employees act in accordance with the specified requirements and rules. In this respect, they not only contain supervisory requirements, but also guide the undertaking’s management systems.

BaFin is currently reviewing the requirements set out in Circular 02/2017 (VA) – Minimum Requirements under Supervisory Law on the System of Governance of Insurance Undertakings (Aufsichtsrechtliche Mindestanforderungen an die Geschäftsorganisation von Versicherungsunternehmen – MaGo ). In particular, the requirements regarding risk management policies are to be streamlined.

Irrespective of this review, BaFin is already using the existing leeway to interpret the requirements relating to the policies in the undertakings’ favour. The MaGo, for example, applies a narrow definition of policies. The circular only provides general information on the contents of the policies in order to allow undertakings the greatest possible freedom. This means that undertakings can decide for themselves what they want to include in their policies, notwithstanding any minimum content. They can streamline their policies and lay down further rules in work instructions. Pursuant to section 23 (3) of the VAG, the approval of the management board at the time of initial implementation and in the event of significant changes, as well as for the annual review, is generally only required for policies referring to requirements on risk management, the internal control system, internal audit and, if applicable, the outsourcing of functions and activities.

The annual review of the policies should be proportional to the undertaking’s risks, which means that in some circumstances it can be very simple and unbureaucratic. It is up to the undertakings to determine the method, scope and level of detail that is appropriate to their risk profile. If an undertaking with a less pronounced risk profile finds that there is no need for adjustment because, for example, business units and systems have not changed, a management board memo may be sufficient to meet the supervisory requirement.

In the case of other mandatory policies, such as those on fit and proper requirements, remuneration and the product approval process (see expert article on the BaFin website dated 2 March 2018), insurance undertakings must determine in a risk-oriented manner the extent to which the management is involved and the intervals at which the reviews are carried out. However, the policies must be reviewed regularly, at least every three years.

Reporting requirements: pillar 3 of Solvency II

The narrative reports (see expert articles on the BaFin website dated 4 March 2017 and 9 March 2018) that insurers must submit to BaFin include the own risk and solvency assessment (ORSA), the regular supervisory report (RSR) and the solvency and financial condition report (SFCR). In addition, undertakings must submit quantitative data in a structured form (quantitative reporting templates – QRTs) on a quarterly and annual basis.

In addition to the quantitative reports that, as part of microprudential supervision, serve as a basis for the supervision of individual undertakings, undertakings also submit to BaFin extensive quantitative information (reports on financial stability and for statistical purposes) that is required by the European Central Bank. BaFin receives these reports and forwards them directly to the ECB. This way, there is only one reporting channel for the undertakings. BaFin has no influence on the scope of these reporting strands.

The industry criticises the narrative reporting for the fact that both the SFCR and the RSR must be submitted even though there are many overlaps, and that the benefits derived from these reports are disproportionate to the efforts involved. Another point of criticism is the conditions under which undertakings can be exempted from the quarterly reporting requirement.

However, the fact that reporting requirements are rule-based requirements and are therefore not subject to the principle of proportionality is often overlooked in the debate. Simplifications are provided for in quantitative reporting only to the extent and under the conditions explicitly laid down in section 45 of the VAG. This means that BaFin can only allow simplifications for quarterly reporting and individual item reporting. However, the proportionality concept is also taken into account in quantitative reporting, since several reporting templates are only required if the undertaking exceeds certain threshold values.

Narrative reporting

The supervisory authority only has room for manoeuvre with the respect to the submission frequency of the RSRs. It may require undertakings to submit their reports annually, every two years or every three years. BaFin takes a risk-based approach and determines the frequency of submission depending on the undertakings’ market significance and quality. For example, small, low-risk undertakings in which no major shortcomings in meeting the quantitative and qualitative supervisory requirements were observed only have to submit an RSR every three years. However, in the years in which no RSR is submitted, all undertakings must prepare a report on any major changes in the areas to which the RSR relates (“change report”). BaFin is bound by this requirement under European law. The contents to be included in the RSR and SFCR are specified in detail in the Solvency II Directive. Deviations from this are therefore not permitted.

Quantitative reporting requirements and possibilities for exemption

At solo level, quantitative reporting in principle includes 70 annual reporting templates and 12 quarterly templates.² At group level, there is a total of 48 annual reporting templates and eight quarterly templates.³

The scope of reporting also depends in part on the type of business the undertaking conducts. No undertaking is required to submit all reporting templates.

At solo level, up to eight of the quarterly reports and seven annual reports can be omitted upon request, while the submission of six or seven reports can be dispensed with at group level. BaFin may grant these simplifications for a maximum of 20 percent of the German life and non-life insurance market. This and other aspects of exemption are governed by section 45 of the VAG, in which the statutory EU requirements are implemented.

Small undertakings should be given priority when considering the possibility of granting a simplification. BaFin approves exemptions from the submission requirement to the extent that they are legally possible and reasonable from a supervisory point of view. BaFin works on the premise that, within the percentage limitation, all eligible undertakings should in principle benefit from all simplifications, to the extent that this is justifiable from a supervisory point of view taking into account the risk situation of the individual undertaking. The annual examination as to whether the exemption can be granted (again) is carried out ex officio.

Regrettably, many undertakings which could, in BaFin’s view, be eligible for exemptions do not make use of this possibility. This reluctance is also due to the fact that the exemptions BaFin can grant are only for one year. Under the current legal situation, the supervisory authorities are required to review annually whether they can continue to grant an exemption. This is in particular due to the qualitative conditions for applying the proportionality principle. This rather cumbersome procedure could be made much more flexible, which BaFin will advocate at European level.

How are undertakings dealing with the principle?

From BaFin's standpoint, insurers use their scope for proportionality rather cautiously. This may be due to the legal uncertainty that exists. BaFin is also aware that there are legislative grey areas within this scope and that there may also be variations within these grey areas. However, the potential for risk-adequate exemptions and simplifications is often not realised.

The problems in applying the proportionality principle have only become apparent since Solvency II entered into force. The industry and BaFin are still gathering practical experience. Close professional cooperation and communication is therefore all the more important. Undertakings should not shy away from dialogue with BaFin.

The determination of the risk profile is the primary basis for the application of the proportionality principle. The first step is for insurers to determine their own risk profile. In doing so, they must comply with the regulatory requirements. Under Solvency II, they must – cumulatively – take account of the nature, scale and complexity of the risks they are, or could be, exposed to. For IORPs, the scale of activities is also a relevant criterion.

There are no specific parameters as to how the individual criteria translate into the structure of the risk profile, i.e. which types of risks lead to a higher or lower risk profile, for example. The size of an undertaking can also be an indicator for determining the risk profile, but it must not be the only one.

The principle also applies to the use of supervisory powers

BaFin must also gear its administrative actions towards the principle of proportionality. It must use the existing scope for discretion down to the level of each insurer through proportional application of the law and ensure equal treatment of comparable situations. The objective is not to apply the principle-based rules as strictly as possible, but rather to apply them in line with the risk profile of the undertaking concerned. BaFin may not impose disproportionate requirements. It is therefore sometimes difficult to determine general requirements and simplifications that are, at the same time, as specific as possible and are suitable for all undertakings.

BaFin’s supervisory review process must also follow a risk-based approach. BaFin verifies that the undertakings comply with the relevant laws when applying the proportionality principle and encourages them to make full use of the leeway provided by law.

Solvency II review

Together with other parts of the regulatory framework, the application of the principle of proportionality by the European supervisory authorities is being reviewed. BaFin will address issues identified in the application of the proportionality principle at national level. It will work to ensure that the principle can be applied more flexibly so that it can provide appropriate relief, especially for lower-risk insurance undertakings. However, it is important that the Solvency II principle, according to which all requirements in principle apply to all undertakings subject to Solvency II, is maintained.

In the course of the Solvency II Review, BaFin will also advocate further simplifications in the calculation of the SCR with the standard formula. It is conceivable to introduce simplifications for risk sub-modules whose contribution to the overall SCR of an undertaking is not of material importance, provided the normal calculation would be disproportionately costly because of this low materiality.

BaFin’s aim is to further strengthen the proportionality concept in reporting as a whole. In revising supervisory reporting, BaFin also aims to redesign the narrative reports. For example, the SFCR should not only be tailored to supervisory requirements, but also to the information needs of the other addressees, including in particular the general public. In addition, the requirements for the various reports should be clarified in terms of content in order to avoid any impression that various reporting templates require the same information.

With regard to quantitative reporting, BaFin advocates improving the quality of certain reporting templates and assessing the possibility of reducing the number of templates. BaFin also aims to make it easier for undertakings to obtain permission for submitting simplified reports by making it easier for supervisors to grant reporting simplifications and exemptions.

IORP II Directive

The set of criteria for the application of the proportionality principle also includes the criterion “size of activities" for IORPs. In some provisions, the terms "size" and "internal organisation" are also used as reference points for proportionality. Due to the special business model of IORPs, these three new features were particularly highlighted for these institutions. Their inclusion in the set of criteria is due to the fact that the provisions of the IORP II Directive were transposed verbatim. The fact that the size of activities is also highlighted does not mean that this criterion takes precedence over all other considerations. Rather, the decision on what is proportional can only be made in conjunction with the other criteria.

As regards the requirements for the governance of IORPs, BaFin is currently preparing a circular which will – among other things – explain BaFin’s interpretation of the proportionality principle in relation to the new criteria in more detail and will also contain information explaining these criteria. The circular is aimed at assisting IORPs in applying the principle.

Summary

From BaFin's point of view, the principle of proportionality has so far proved largely successful. However, it should always be examined whether the actual application of the principle needs to be optimised in specific areas. This applies not only to proportionality, but also to other aspects of the principle-based Solvency II regime.

It is undisputed that the issues relating to the application of the principle of proportionality have not yet been clarified conclusively. BaFin and the industry are already engaged in a productive dialogue on new ideas for solutions. Neither the supervisory authority nor the industry should shy away from any extra effort that might be required, as this is a good investment to achieve appropriate solutions for all stakeholders. Reliable solutions create legal certainty and make the principle more tangible and suitable for practical application.

Even though IORPs may raise issues which so far have not been raised by other undertakings subject to Solvency II, they will nevertheless profit from the experience gained to date. BaFin relies on maintaining a constructive dialogue with the industry in order to find solutions that everyone can agree on.

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