Background and scope of the Draft Opinion
On July 25, 2019, EIOPA published a draft Opinion on the supervision of remuneration principles in the insurance and reinsurance sector (the Draft Opinion)1. When (as opposed to if) finalized this will affect a host of (re-)insurance firms already operating across the EU-27 as well as those looking to set up operations as a result of Brexit or otherwise.
EIOPA's Draft Opinion2 aims to give guidance to supervisory authorities on how to challenge and shape sound remuneration principles in the European insurance market. In doing so, EIOPA focuses on staff that it has identified as potential "higher risk takers", while still permitting a proportionate approach. EIOPA's use of an Opinion aims to promote supervisory convergence in the regulatory practice of National Competent Authorities (NCAs) in the EU-27 while harmonizing the approach taken to (re-)insurance firms and their remuneration policies and limiting excessive risk taking.
This Client Alert, as part of our dedicated Insurance Insight series, assesses the content of the Draft Opinion and EIOPA's as well as NCAs' possible next steps and whether these will follow the principles adopted in EU banking sector legislation and notably the CRD IV/CRR regime, as amended. While some of EIOPA's principles may seem familiar to pay reforms and supervisory approaches that already apply in the banking sector, the provisions in EIOPA's Draft Opinion are specific to the (re-)insurance sector. Even if EIOPA's revisiting of its supervisory approach may be looking to the EU's existing and on-going efforts in the banking sector for inspiration on deliverables, the body of (re-)insurance firms needing to comply with the expectations set in the Draft Opinion may require some very different solutions to deal with tricky pay discussions.
Technical context of Solvency II and national law of member states
By contrast, with the post-crisis reforms and the EU's remuneration rules applicable in the banking sector, the provisions of Directive 2009/138/EC (Solvency II)3 (currently) do not have general remuneration rules that apply to the (re-)insurance industry. Instead, such rules are provided in a somewhat limited form through two articles in Commission Delegated Regulation (EU) 2015/35 (the Delegated Regulation)4. This requires firms to have a written remuneration policy that must comply with specific principles and provisions of national law, which may differ between jurisdictions and national-led supervisory regimes. However, these rules on pay only provide for high-level requirements, leaving a considerable amount of discretion to relevant firms and NCAs supervising them. These national differences do not facilitate convergence in the terms of the law and may lead to divergent national supervisory practice in EU/EEA Member States. The Draft Opinion aims to change that and create a minimum and uniform level of harmonization across the EU, which also works with existing provisions of national law.
What are the key points of the Draft Opinion?
In the Draft Opinion, EIOPA stresses risk-based supervision. According to EIOPA, risk-based supervision of a remuneration policy means that the supervisory authorities should have a two-dimensional approach when assessing the relevant risks. The first dimension should focus on the undertakings' overall risk profile, while the second dimension should examine the design of the concrete remuneration policy5.
Staff of supervised undertakings that are not covered by the Draft Opinion may be subject to a proportionate and more flexible approach.6 Members of the administrative, management and supervisory body (AMSB) and the most highly paid employees of global systemically important undertakings (G-SIIs) would not only be subject to the guidance provided in the Draft Opinion but also to the FSB Principles and Standards for Sound Compensation Practices if these principles and standards apply in their respective jurisdictions.7EIOPA is also keen to stress that the benchmarks included in the Draft Opinion do not constitute hard targets but rather building blocks that supplement individual on-going supervisory dialogue.8
Supervision of remuneration policies
Scope of application
The Draft Opinion's key provisions are on the remuneration arrangements applying to staff that can be classed into four categories set by EIOPA. These include relevant persons whose annual variable remuneration exceeds €50,000 and where such a variable component represents more than a quarter of that staff member's total annual remuneration. The four categories include:
- AMSB members;
- other executive directors who effectively run the undertaking;
- key function holders as defined in EIOPA's Guidelines on the system of governance; and
- categories of staff whose professional activities have a material impact on the undertakings' risk profile (material risk takers or MRTs).9
Fixed and variable components of remuneration have to be balanced (Article 275(2)(a) of the Delegated Regulation)
EIOPA advises that where remuneration schemes have fixed and variable components the proportion of the components should be such that employees do not become overly dependent on the variable components, as this could endanger the sound and prudent management via encouraging risk taking as a means of maximizing remuneration.10
Supervisory authorities are also recommended to pay specific attention to very low fixed remunerations, considering the context of national remuneration practices.11
A substantial portion of the variable remuneration has to be deferred (Article 275(2)(c) of the Delegated Regulation)
As per the Delegated Regulation, EIOPA advises that the length of the deferral period should not run less than three years.12 Supervisory authorities should also use their judgement to consider the need for a deferral rate higher than 40% and/or a longer deferral period as part of a risk-based approach.13
The recommended deferral rate is higher than 40% in cases of a particularly high variable remuneration, e.g. in case of a ratio higher than 1:1.14 When the deferral is lower than 40%, supervisory authorities are advised to engage with the undertakings to better understand the specific situation.
Financial and non-financial criteria have to be taken into account when assessing an individual's performance (Article 275(2)(d) of the Delegated Regulation)
EIOPA merely reproduces the legal standard of the Delegated Regulation when it states that where variable remuneration is performance related, the total amount of variable remuneration has to be based on a combination of the assessment of the individual's performance, the performance of the business unit concerned and the overall result of the undertaking or group to which the undertaking belongs.15 Related to that, supervisory authorities should set out financial (quantitative) and non-financial (qualitative) criteria relating to the individual's ex ante performance and describe the consequences on the pay-out of variable remuneration when these criteria are not met by the individual.16
EIOPA recommends that both criteria also include objectives and measures for which the staff member has some direct influence.17 The assessment of performance should be set in a multi-year framework.18 The assessment should also take into account (1) financial (quantitative) criteria that cover a period that is long enough to capture the risk taken by staff members; and (2) non-financial (qualitative) criteria that should contribute to the creation of value for the undertaking.19 Financial and non-financial criteria should be appropriately balanced.
The Draft Opinion provides an example on how this would be achieved in the form of the following: Where the criteria are 80% financial and 20% non-financial, the supervisory authority is entitled to conclude that the assessment framework is not appropriately balanced. The general idea, according to EIOPA, is that non-financial criteria should not be negligible and should also have a substantial value as indicators. Supervisory authorities are allowed to challenge the balance of the criteria if the criteria are not consistent with a sound and effective risk-adjusted remuneration policy or alternatively do not sufficiently reflect the undertaking's strategic views.20
The measurement of performance has to include a downwards adjustment for exposure to current and future risks (Article 275(2)(e) of the Delegated Regulation)
In its Opinion EIOPA interprets the term downwards adjustment and concludes that it embraces all kinds of adjustments.21 Consequently, variable remuneration should be adjusted downward if members of staff do not meet their personal objectives or their business units and/or the undertaking as a whole fails to do so.22 EIOPA takes the view that an undertaking's remuneration policy should prescribe downward adjustment if the undertaking is likely to breach or has breached the Solvency Capital Requirement.23
EIOPA encourages supervisory authorities to require a clear description of the downwards adjustment(s) from undertakings. The scheme should be four-fold: It should:
- show how the short to long-term risks, the cost of capital, (internal) capital requirements, as well as the dividends policy have been taken into account;
- include examples of how the downwards adjustment works;
- include the rationale for the chosen downwards adjustment and the triggers used; and
- ensure that downwards adjustments are designed in a way that, in the event of an individual's negative contribution to the undertakings' results in any year of the deferral period, any unvested portion of the variable part of the remuneration may be subject to malus.24
Termination payments have to be related to performance achieved over the whole period of activity and be designed in a way that does not reward failure (Article 275(2)(f) of the Delegated Regulation)
Termination payments are regularly seen as a form of variable remuneration. The Draft Opinion lists examples of amounts to be taken or not taken into account when determining the fixed/variable remuneration ratio.25 Undertakings' remuneration policies should also specify the use of termination payments, include the maximum payment or the criteria for determining the amount of the payment.26
In EIOPA's view, termination payments may include redundancy payments, and may be subject to a non-competition clause.27 The Draft Opinion also includes examples of payments that would qualify as termination payments, e.g.:
- the undertaking terminates contracts because of a failure of the undertaking;
- the undertaking terminates a contract following a material reduction of activities in which the staff member was active or where business areas are acquired by other undertakings without the option for staff to stay employed in the acquiring undertaking;
- the undertaking and staff members agree on a settlement in case of a potential or actual labor dispute.28
EIOPA also takes the view that a substantial part of the termination payment should be deferred in time.29
Payments have to reflect the performance achieved over time and must not reward failure.30 The severity of failure will determine the level of the termination payment and in some events may lead to no termination payment being awarded at all.31
Thus, the Draft Opinion distinguishes between failures of the undertaking and failures of the identified member of staff.32 Termination payments should not be made when (1) a failure of the identified member of staff warrants the immediate cancellation of the contract or the dismissal of staff; (2) a member of staff resigns voluntarily in order to work for a different legal entity, unless such a payment is required by national labor law.33
Recommendations on composition of variable remuneration
EIOPA recommends that supervisory authorities ensure that undertakings award 50% of variable remuneration in shares, equivalent ownership or share-linked instruments, if proportionate and feasible.34 These instruments are to be subject to an appropriate retention policy designed to align incentives with the longer-term interests of the undertaking and apply to both the portion of the variable remuneration component that has to be deferred in time as well as the one that is not deferred in time.35
In EIOPA's view, supervisory authorities can also exercise their own judgment and conclude that the 'composition requirement' should be applied in a simpler and less burdensome manner for specific undertakings.36
Should financial instruments not be available to undertakings due to their legal form, such undertakings are encouraged to consider developing equivalent non-cash instruments.37
EIOPA encourages supervisory authorities to collect qualitative and quantitative data to enable them to perform supervisory review of the remuneration principles in accordance with the Draft Opinion. Either regular supervisory reporting or a specific request can in that case be instruments for data collection.38
Monitoring by EIOPA
EIOPA pledges to start monitoring the application of this Opinion by the supervisory authorities two years after its publication.39
So what about continuing national laws?
Despite any convergence efforts by EIOPA's Draft Opinion, to the extent that relevant (re-)insurance undertakings are not subject to Solvency II, the national laws of EU Member States may stipulate relevant requirements. For example, German regulatory law's relevant key principles are set out in the Remuneration Ordinance for Insurance Undertakings (Versicherungsvergütungsverordnung –VersVergV)40. The VersVergV stipulates, amongst other requirements, that managing directors are responsible for appropriate remuneration schemes within their firms.
The VersVergV also provides for a split of fixed and variable components, deferrals of variable payments and the overarching principle that decision makers must bear the consequences of materialized risks and/or negative developments in insurance undertakings through potential cuts in their remunerations. While EIOPA's efforts mark a first step towards convergence as opposed to creating a pan-EU full harmonized regime, the overall impact of what is being proposed, if the Draft Opinion were to be finalized in its current form, would possibly cause some changes to the provisions of national law and certainly amend and indeed sharpen some supervisory practices of certain NCAs. These changes are likely to take time to fully trickle through.
Assuming the Draft Opinion moves from a guiding document to becoming fully binding by 2021, affected firms will need to:
- be careful with the proportion assigned to the variable component in a remuneration scheme with both fixed and variable components as guaranteed variable remuneration is not consistent with sound risk management;
- base the amount of variable remuneration on a combination of the individual's performance, the business unit's performance and the overall firm or group's performance;
- award 50% of variable remuneration in shares, equivalent ownership or share-linked instruments;
- be careful with termination payments as, depending on the type of payment, they may not form part of the variable remuneration component;
- distinguish between failures of the member of staff and failures of the firm in relation to the remuneration assigned;
- assess staff's performance not just in per annum reviews but rather in a multi-year framework;
- prescribe downward adjustments only if the firm is likely to breach or has breached the Solvency Capital requirement;
- provide supervisory authorities with qualitative and quantitative data to enable them to perform supervisory review of the remuneration principles
While EIOPA's Opinion is definitely a welcome document because it fills a gap in relation to remuneration in the insurance sector that existed until now, it seems that the documents tries to achieve what has already been done in other sectors, namely banking in this case. EIOPA's regime however, has insurance-specific features that make it stand out as well as making it more suited to its insurance purpose.
Firms are thus encouraged to look at their remuneration policies and perform a gap analysis of what changes they need to make to comply with the requirements announced in the Draft Opinion.
It is interesting to note also that the essential building block on which the Draft Opinion is built comes from the same G-20 2009 Pittsburgh Commitments41 that have influenced Basel II and then the drafting of the CRD IV Directive/CRR Regulation. The common thread here is that in order to discourage disproportionate risk taking, firms are being limited in what they can pay. As such, the decisions made 10 years ago still resonate today and are being implemented across the EU even if EIOPA is trailing at a slower pace to that of its sister European Supervisory Authorities.
It remains to be seen what the outcome will be ahead of the close of the consultation on the Draft Opinion on September 30. Until then, enhancing supervisory convergence by focussing on a set of remuneration principles is a step in the right direction.
5.Note 2.7 of EIOPA's "Consultation Paper on Draft Opinion on the supervision of remuneration principles in the insurance and reinsurance sector", EIOPA-19/299, dated 25 July 2019, (the Draft Opinion) available here.↩
23.Note 3.14 of the Draft Opinion, available here as well as the footnote within the Draft Opinion itself which states that "[i]n line with EIOPA 's Opinion to institutions of the European Union on the harmonization of recovery and resolution frameworks for (re)insurers across the Member States, EIOPA believes that supervisory authorities should have as an early intervention power, the power to require undertakings to limit variable remuneration and bonuses. If this power is already available at national level, supervisory authorities should consider using this power in case of a potential breach of the SCR."↩
Dentons is the world's first polycentric global law firm. A top 20 firm on the Acritas 2015 Global Elite Brand Index, the Firm is committed to challenging the status quo in delivering consistent and uncompromising quality and value in new and inventive ways. Driven to provide clients a competitive edge, and connected to the communities where its clients want to do business, Dentons knows that understanding local cultures is crucial to successfully completing a deal, resolving a dispute or solving a business challenge. Now the world's largest law firm, Dentons' global team builds agile, tailored solutions to meet the local, national and global needs of private and public clients of any size in more than 125 locations serving 50-plus countries. www.dentons.com.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.