Circular NBB_2016_07 on Segregated Funds

NBB_2016_07 – 25 April 2016 Circular – P. 1/11 boulevard de Berlaimont 14 – BE-1000 Brussels tel. +32 2 221 38 12 – fax + 32 2 221 31 04 company number: 0203.201.340 RPM Brussels www.bnb.be

Circular
Brussels, 25 April 2016
Reference: NBB_2016_07 your contact:
Patricia Kaiser tel. +32 2 221 34 31 – fax +32 2 221 31 04 patricia.kaiser@nbb.be

Circular on Segregated Funds

Scope
Belgian insurance or reinsurance undertakings.
Insurance or reinsurance undertakings that are part of a Belgian group within the meaning of Article 339, 2° of the Law of 13 March 2016 on the status and supervision of insurance or reinsurance undertakings.
Belgian undertakings that are part of a Belgian financial conglomerate within the meaning of Article 340, 1° of the aforementioned Law of 13 March 2016.
Branches of undertakings from third countries carrying on insurance [or reinsurance] activities in Belgium.
This circular applies to mutual insurance companies defined in Article 15, 79° of the aforementioned Law of 13 March 2016. For these undertakings, "the Bank" should be replaced by "the Office for the Supervision of Mutualities and National Unions of Mutualities" as defined in Article 15, 84° of the same Law. This circular does not apply to insurance undertakings referred to in Articles 275, 276 or 294 of the aforementioned Law of 13 March 2016.

Summary/Objectives
This circular aims to explain how to identify restricted own funds, determine the assets and liabilities of the segregated fund, calculate the notional amount of the SCR, compare the SCR and restricted own funds, calculate the SCR for multiple segregated funds and calculate the SCR with an internal model.

Legal References
The Law: The Law of 13 March 2016 on the status and supervision of insurance or reinsurance undertakings.
Regulation 2015/35: Delegated Regulation (EU) 2015/35 of the Commission of 10 October 2014 supplementing Directive 2009/138/EC of the European Parliament and of the Council on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II).

Circular – P. 2/11 NBB_2016_07 – 25 April 2016

Structure
I. Objectives
II. Definitions
III. Additional Information
IV. Entry into Force
V. Guidelines on Segregated Funds

Madam,
Sir,

I. Objectives
This circular relates to Articles 80, 81, 216 and 217 of Regulation 2015/35.
It aims to promote a consistent approach by helping undertakings and supervisory authorities to:
(a) determine whether elements of own funds have limited capacity to fully absorb losses on a going concern basis due to their non-transferability within the undertaking, taking into account the different national frameworks and the specificity of products that may give rise to segregated funds, and taking into account how these elements of own funds are calculated; (b) determine the assets and liabilities that make up the segregated fund by identifying the assets and liabilities associated with restricted elements of own funds; (c) calculate the notional amount of the Solvency Capital Requirement (hereinafter, the "SCR") for each segregated fund, when the SCR is calculated using the standard formula or an internal model; (d) compare the amount of restricted elements of own funds included in the segregated fund and the notional amount of the SCR of the segregated fund; (e) calculate the SCR if there is one or more segregated funds (for undertakings); (f) if the SCR is calculated using an internal model, define the nature of the evidence that undertakings should provide to the Bank for the purpose of assessing the system to measure the effects of diversification, taking into account any significant restriction on diversification resulting from the existence of segregated funds. The requirement to calculate the notional amount of the SCR of a segregated fund does not mean that undertakings are required to maintain an amount of own funds included in a segregated fund equal to or greater than the notional amount of the SCR. However, if the amount of own funds included in a segregated fund is less than the notional amount of the SCR, the undertaking does not comply with its SCR, unless the total of own funds included in the segregated fund and in the remaining parts of the undertaking combined is sufficient to cover this SCR, after application of the limits referred to in Article 82 of Regulation 2015/35. These guidelines, with the exception of guidelines 1 to 5, are relevant for the treatment of asset and liability portfolios to which a matching adjustment is applied following approval by the Bank.

NBB_2016_07 – 25 April 2016 Circular – P. 3/11

II. Definitions
In the absence of a definition in this circular, the terms have the meaning defined in the legislative and regulatory acts referred to therein.

III. Additional Information
This circular is part of the harmonised implementation of the principles of Directive 2009/138/EC of the European Parliament and of the Council of 25 November 2009 on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II), as determined by the guidelines of the European Insurance and Occupational Pensions Authority. Undertakings may consult these guidelines for information at the following address: https://eiopa.europa.eu/publications/eiopaguidelines.

IV. Entry into Force
This circular applies from 23 March 2016.

V. Guidelines on Segregated Funds

Guideline 1 – Characteristics and scope of segregated funds Undertakings should define segregated funds by referring to the following characteristics:
(a) the existence of a restriction on assets related to certain liabilities on a going concern basis, which would result in restricted own funds within the activity of an undertaking, is the main characteristic of a segregated fund; (b) segregated funds may arise if profit participation is part of the agreement, as well as in the absence of profit participation; (c) even though the segregated assets and liabilities should form an identifiable unit, as if the segregated fund were a separate undertaking, it is not necessary that these elements be managed together as a separate unit or that they form a separate sub-fund for a segregated fund to arise; (d) if the product or yield of the assets included in the segregated fund also falls under the agreement concerning this fund, undertakings are able to identify them at any time; in other words, they are able to define elements as covered by the agreement giving rise to the segregated fund or as falling under it.

Guideline 2 – Agreements and products generally not within the scope of segregated funds When defining segregated funds, undertakings should consider that the following agreements and products generally do not fall within the scope of segregated funds:
(a) life insurance contracts under which the investment risk is borne by the policyholder) referred to in Article 192, paragraph 1 of the Law;

Circular – P. 4/11 NBB_2016_07 – 25 April 2016

(b) life insurance contracts under which the investment risk is borne by the policyholder when the benefits provided are directly linked to the value of units of an UCITS within the meaning of Directive 2009/65/EC or to the value of assets contained in an internal fund held by the insurance undertaking generally divided into units, referred to in Article 192 paragraph 3 of the Law; (c) provisions, including technical provisions and equalisation reserves as well as reserves established in accounts or financial statements drawn up in accordance with the requirements applicable in a particular jurisdiction, are not segregated funds solely because they are established in these financial statements; (d) conventional reinsurance activities, provided that individual contracts do not give rise to restrictions on the assets of undertakings; (e) assets held for the purpose of covering technical provisions and similar agreements established to protect policyholders in the event of liquidation proceedings, either for all policyholders of the undertaking or for distinct sections or groups of policyholders of the undertaking, including assets entered in the permanent inventory referred to in Article 195 of the Law. (f) the separation of life and non-life activities in multi-line undertakings that simultaneously carry out life insurance and non-life insurance activities or health insurance activities referred to in Articles 222 to 229 of the Law but taking into account the fact that a segregated fund may still arise in one or the other or in both parts comprising multi-line undertakings depending on the nature of the underlying activities; (g) surplus funds are not segregated solely because they are surplus funds, but they could be if they are produced in a segregated fund; (h) the transfer of a portfolio to an undertaking during the restructuring of an activity, when the separation of the assets of the existing activity of the recipient undertaking from the assets of the transferred portfolio does not constitute a segregated fund, if this separation was put in place under national legislation to protect the existing activity against the transferred portfolio only on a temporary basis; (i) experience funds, including dedicated asset funds referred to in Article 218 of the Law, where policyholders are entitled to a share of the fund's experience according to the terms provided in the policy documents, generally in the form of a predetermined minimum percentage, and are entitled to no other unallocated amount in accordance with this specified profit participation scheme. Amounts allocated to policyholders are included in technical provisions. Amounts not allocated to policyholders are fully transferable, they can be returned to shareholders or other capital providers, be used to absorb potential losses or be used, without this being mandatory, to increase policyholder benefits and thus become part of the own funds to which no restriction applies;

NBB_2016_07 – 25 April 2016 Circular – P. 5/11

Guideline 3 – Restrictions giving rise to segregated funds Undertakings should identify in their activity any restrictions affecting assets and own funds and associated liabilities concerning contracts, policyholders or risks for which these assets and own funds can be used. In order to define such restrictions giving rise to a segregated fund, undertakings should take into account at least:
(a) contractual clauses;
(b) any separate legal device applicable in addition to policy clauses; (c) provisions contained in articles of association, statutes or any other document giving rise to the creation or organisation of the undertaking; (d) national legislation or regulation concerning product design or the organisation of the relationship between undertakings and their policyholders: segregated funds arise if, due to legal provisions protecting the general interest in a Member State, an undertaking must use particular assets only for the purpose of a specific part of its activity; (e) provisions of European Union law, transposed or directly applicable; (f) agreements specified in an order adopted by a judicial authority or any other competent authority requiring the separation of assets or own funds, or imposing restrictions on them, in order to protect one or more groups of policyholders. Undertakings should take into account all restrictions affecting assets and own funds existing at the time of the SCR calculation, regardless of the duration for which these restrictions apply on a going concern basis.

Guideline 4 – Scope of the treatment of segregated funds Undertakings that detect characteristics and restrictions giving rise to a treatment of segregated funds should, at least, compare the agreements that exist within their activity with the following types of segregated funds:
(a) a fund of assets and liabilities concerning an activity with profit participation, only available to cover losses occurring with regard to particular policyholders or concerning particular risks and when the following main features are present:
(i) policyholders in the segregated fund have distinct rights compared to other activities underwritten by the undertaking; (ii) there are restrictions on the use of assets and their yield within this fund, in order to meet commitments or losses arising outside the fund; (iii) a surplus of assets over liabilities is generally maintained in the fund, and this surplus constitutes restricted own funds, given that its use is limited as indicated in point ii);

Circular – P. 6/11 NBB_2016_07 – 25 April 2016

(iv) there is generally a profit participation in the segregated fund, according to which policyholders receive a minimum proportion of the fund's profits, which are distributed by means of additional benefits or reduced premiums and, if applicable, shareholders can then receive the balance of these profits; (b) a legally binding agreement or trust created for the benefit of policyholders, when, in the policy documentation, or outside of it, an agreement provides that certain products or assets will be placed in trust or will be subject to a legally binding agreement or charge for the benefit of specified policyholders; (c) segregated funds, which reflect restrictions on particular assets or own funds, specified in articles of association, statutes or any other document giving rise to the creation or organisation of the undertaking; (d) segregated funds that arise to reflect the effects of restrictions or agreements specified in national law; (e) agreements falling within the scope of European Union law, including the Solvency II Directive and Regulation 2015/35:
(i) Article 162 of the Law, which introduces a segregation requirement concerning the provision of occupational retirement and retirement benefits. Consequently, this type of segregated fund must be taken into account for any adjustment of own funds in accordance with Articles 80 and 81 of Regulation 2015/35. However, the requirement provided for in Article 217 of Regulation 2015/35 to calculate the SCR as the sum of the notional amounts of the SCR for the segregated funds and for the remaining part is not applicable, given that Article 162 of the Law allows for the accounting of diversification effects provided that the interests of policyholders and beneficiaries in other Member States are preserved; (ii) Article 4 of Directive 2003/41/EC, which provides for the possibility for Member States to apply certain provisions of this Directive to the provision of occupational retirement activities carried out by insurance undertakings, provided that a segregation requirement is applied to all assets and liabilities corresponding to said activities. This provision may be relevant for activities treated in this manner for undertakings that have not obtained authorisation under Article 162 of the Law. In this case, the requirements set out in Articles 81 and 217 of the implementing measures are applicable. Until 31 December 2019, Article 308 ter, paragraph 15, of the Solvency II Directive provides for a transitional measure for this activity, which allows the application of legislative, regulatory and administrative provisions that Member States have adopted concerning the relevant articles of Directive 2002/83/EC. As Belgium has not implemented the provisions referred to in Article 4 of Directive 2003/41/EC by 23 May 2014, segregated funds resulting from the application of this article do not exist with regard to insurance activities in Belgium. Portfolios subject to a matching adjustment must be considered and treated as segregated funds. Indeed, undertakings should recognise that the reduced transferability of assets and the reduced possibilities for diversification between the portfolio assigned under matching adjustment and the rest of the undertaking mean that the valuations, assumptions and calculations referred to in Articles 81, 216, 217 and 234 of Regulation 2015/35 apply to portfolios under matching adjustment. Undertakings should apply guidelines 6 to 17 if they possess portfolios under matching adjustment.

NBB_2016_07 – 25 April 2016 Circular – P. 7/11

Guideline 5 – Materiality
If the segregated fund is not material, Article 81 of Regulation 2015/35 allows undertakings to exclude the total amount of restricted elements of own funds from the amount eligible to cover the SCR and the Minimum Capital Requirement (hereinafter, the "MCR"). In this case, in accordance with Article 216 of Regulation 2015/35, undertakings are not required to calculate the notional amount of the SCR for the segregated fund. However, undertakings should include the assets and liabilities of the immaterial segregated fund in the remaining part of the undertaking. These assets and liabilities will be part of the calculation of the undertaking's global SCR. Undertakings should examine the materiality of a segregated fund by assessing:
(a) the risks arising from or covered by the segregated fund; (b) the assets and liabilities included in the segregated fund; (c) the amount of restricted own funds included in the segregated fund, the volatility of these amounts over time and the proportion that restricted own funds represent in the total own funds; (d) the proportion that the segregated fund represents in the total assets and capital requirements of the undertaking, on an individual or combined basis with other segregated funds; (e) the possible impact of the segregated fund on the calculation of the SCR due to limited risk diversification possibilities.

Guideline 6 – Assets included in a segregated fund Undertakings should define the assets included in a segregated fund as comprising assets, or baskets of assets, specified and any associated cash flows restricted by the agreements giving rise to the segregated fund, as described in guideline 3.

Guideline 7 – Liabilities included in a segregated fund Undertakings should define the liabilities included in a segregated fund only as those properly attributable to the policies or risks covered by the segregated fund or for which the restricted assets can be used. When determining the liabilities included in a segregated fund with regard to an activity with profit participation, undertakings should include in the best estimate of liabilities any discretionary benefit that the undertaking intends to pay in the future. Undertakings should ensure that the valuation of liabilities, including, where applicable, future discretionary benefits, used for the purposes of the segregated fund calculations, is identical to that which would have been established for these liabilities if they were not included in a segregated fund.

Guideline 8 – Future transfers to shareholders When applying Article 80, paragraph 2 of Regulation 2015/35, undertakings should take into account future transfers to shareholders as:
(a) being only relevant in the context of the activity with profit participation; (b) arising when the corresponding future discretionary benefits are recognised in the best estimate of liabilities;

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Circular – P. 8/11 NBB_2016_07 – 25 April 2016

(c) forming part of the surplus of assets over liabilities of the segregated fund, and not being a liability of the segregated fund; (d) including transfers relating to profit-sharing participations already included in guaranteed benefits, provided that the corresponding distribution to shareholders has not already been transferred out of the segregated fund.

Guideline 9 – Calculation of the notional SCR amount of a segregated fund: standard formula

Companies should follow the following steps when applying the method described in Article 217 of Regulation 2015/35:

(a) when applying the SCR calculation method to assets and liabilities included in a segregated fund as if the segregated fund were a separate entity, companies should include a capital requirement for operational risk as well as any relevant adjustment to take into account the loss-absorbing capacity of technical provisions and deferred taxes; (b) when aggregating capital requirements according to the worst-case scenario for the company as a whole for each sub-module and risk module using the aggregation procedure of the standard formula referred to in Article 154 of the Act, companies may recognize risk diversification within the segregated fund; (c) the capital requirement at the level of each segregated fund should be calculated deducting the mitigating effects of any future discretionary benefits. In the case of profit-sharing, assumptions regarding the variation of future profit-sharing rates must be realistic and duly take into account the impact of the shock at the level of the segregated fund, including the impact on the value of future transfers to shareholders, and any contractual, legal or regulatory requirement governing the profit-sharing scheme; (d) if, due to bidirectional scenarios, the equity capital requirement for the worst-case scenario is negative, even taking into account a possible increase in liabilities due to profit-sharing mechanisms, and thus results in an increase in basic own funds included in the segregated fund, the equity capital requirement should be set to zero.

Guideline 10 – Calculation of the notional SCR amount of a segregated fund: internal model

In order to calculate the notional SCR amount of a segregated fund in accordance with Article 81, paragraph 1, point a) of Regulation 2015/35, companies should ensure that:

(a) the internal model is capable of performing the calculation of the notional SCR amount for each segregated fund as if each segregated fund were a separate entity conducting only the activity included in that segregated fund; (b) the calculation of each notional SCR amount is consistent with the SCR calculation for the company as a whole; (c) risk mitigation techniques and future management decisions taken into account to calculate the notional SCR amount of each segregated fund are consistent with the risk mitigation techniques and future management decisions taken into account for the segregated activity in the SCR calculation for the company as a whole, and with Guideline 9;

NBB_2016_07 – 25 April 2016 Circular – P. 9/11

(d) the method and assumptions applied to calculate the notional SCR amount for each segregated fund are consistent with those used for the same types of assets, liabilities and risks in the SCR calculation for the company as a whole; (e) risk mitigation techniques, future management decisions, methods or assumptions for calculating the notional SCR amount different from those used to calculate the SCR of the company as a whole are used only when it is necessary to produce a compliant notional SCR amount, and any justification regarding these differences is documented.

Guideline 11 – Determining whether restricted own funds included in a segregated fund exceed the notional SCR amount: standard formula and internal model

Companies should compare the amount of restricted own funds included in the segregated fund with the notional SCR amount of the segregated fund calculated, as provided for in Guideline 9 or Guideline 10.

The adjustment provided for in Article 81, paragraph 2, of Regulation 2015/35 only has the effect of allowing an amount of own funds equal to the notional SCR amount to contribute to the coverage of the SCR of the company as a whole and to the coverage of the MCR.

If the amount of own funds within a segregated fund is equal to or less than the notional SCR amount of the segregated fund, companies should make no adjustment to own funds since there are no restricted own funds exceeding the notional SCR amount. In this case, all own funds within the segregated fund are available to cover the SCR and MCR.

Guideline 12 – Calculation of the SCR of the company as a whole in the event of the existence of segregated funds: standard formula

When calculating a separate notional SCR amount for the remaining part of the company, companies should treat the assets and liabilities of this remaining part of the company as if it were a separate entity and apply Guideline 9.

Without prejudice to Article 227, paragraph 2, of Regulation 2015/35, when calculating the SCR as the sum of the notional SCR amounts for each segregated fund and for the remaining part of the company, companies should not take into account any potential diversification benefits between the segregated funds or between the segregated funds and the remaining part of the company.

Companies should set any negative notional SCR amounts to zero before aggregating these amounts with any positive notional SCR amounts of the segregated funds and the remaining part of the company.

Circular – P. 10/11 NBB_2016_07 – 25 April 2016

Guideline 13 – Calculation of the SCR of the company as a whole in the event of the existence of segregated funds: internal model

In accordance with Article 234, point b) ii), of Regulation 2015/35, companies using an internal model should ensure that:

(a) they take into account how the notional SCR amount is calculated for each segregated fund; (b) they take into account how any restrictions on diversification resulting from the existence of segregated funds are taken into account by the system to measure diversification effects; and (c) they provide evidence and information to the Bank regarding:
(i) the nature of the insurance activity in each relevant segregated fund and its similarities or differences with the activity conducted in other segregated funds and in the remaining part of the company; (ii) the degree of correlation of risks related to these lines of activity; (iii) historical data demonstrating the impact of losses affecting different parts of the activity; (iv) the justification and nature of the restrictions affecting each relevant segregated fund; (v) an explanation of the source of diversification given these restrictions and the definition of the key variables that determine dependencies; (vi) an analysis of any non-linear dependency and any significant lack of diversification under extreme scenarios; (vii) the extent to which the data provided in accordance with points i) to vi) support the observation of diversification effects between the segregated funds or between the segregated funds and the remaining part of the company.

In accordance with Article 234, point b) ii), of Regulation 2015/35, the Bank will assess:

(a) how the notional SCR amount is calculated and how diversification benefits are taken into account in the internal model; (b) whether the assumptions underlying the system used to measure diversification effects are justified on an empirical basis, taking into account the elements referred to in Guideline 13 point c).

Guideline 14 – Application of the calculation method to similar segregated funds

If a company intends to apply the same calculation method to multiple segregated funds with similar characteristics, it should demonstrate to the satisfaction of the Bank that the method produces sufficiently accurate results for each of the similar segregated funds.

Guideline 15 – Continuous assessment: actions by the company using an internal model

In the event of changes in circumstances affecting the accuracy of the evidence or information provided in accordance with Guideline 13, and potentially affecting the Bank's assessment regarding the appropriate consideration of the reduction in diversification in the results of the company's internal model, companies should determine whether it is necessary to modify the internal model, according to the modification policy of said model. Companies should notify the Bank of any subsequent minor modifications as part of the quarterly declaration of minor modifications. Companies should submit to the supervisory authorities a request for approval of modifications classified as major according to the internal model modification policy.

Guideline 16 – Declaration of the split SCR by risk module for companies possessing segregated funds or portfolios under equalization adjustment

When calculating the amount of the SCR split by risk module for the purposes of the report referred to in Article 311, paragraph 2, point a), of Regulation 2015/35, and the information for the public referred to in Article 297, paragraph 2, point b), of Regulation 2015/35, companies using the standard formula should identify the effects of non-diversification. To this end, companies should allocate, by risk module, the difference between the sum of the notional SCR amounts calculated in accordance with Article 217 of Regulation 2015/35 and the SCR of the company as if there were no loss of diversification. When calculating this difference, companies may use one of the simplifications described in the technical annex.

The approach used should be applied consistently over time.

A copy of this circular is sent to the auditor(s), approved reviewer(s) of your establishment.

We ask you to accept, Madam, Sir, the expression of our distinguished sentiments.

Jan Smets
Governor

Annex: 1