On 30 December 2016, the Companies Act 2006 (Distributions of Insurance Companies) Regulations 2016 (the “Regulations“) came into force. The Regulations apply to distributions made on or after that date by reference to accounts prepared for any period ending on or after 1 January 2016. A copy of the Regulations is available here.
The purpose of the Regulations is to define the mechanism by which long-term insurance companies are required to calculate amount of their distributable profits, following the implementation of certain changes arising from the Solvency II Directive.
Under the Companies Act 2006 (the “CA 2006“), a company’s distributable profits are generally defined as being its accumulated, realised profits (so far as not previously utilised by distribution or capitalisation), less its accumulated, realised losses (so far as not previously written-off in a reduction or reorganisation of capital).
The position, however, is slightly different for long-term insurers. Due to the nature of the liabilities they assume (e.g. annuities), a relatively large proportion of the total assets of a long-term insurer are invested in long-dated assets, which provide a better “match” in cash-flow terms for their liabilities. Those assets are held for many years without being traded, and often are not readily realisable. This can present a difficulty in relation to the calculation of distributable profits – under ordinary accounting rules, any upward revaluation of long-term liabilities is viewed as being immediately realised, whereas an increase in the value of long-term fixed assets will generally not be treated as realised until the assets are sold for cash, or are readily realisable for cash.
For long-term insurers, the application of the ordinary rules could result in high volatility in distributable profits, since any increase in liabilities would be treated as a loss, while the corresponding increase in the value of the assets that the insurer holds to cover those liabilities might not be recognised due to their not being readily realisable. This could also distort the investment incentives for long-term insurers, as it would discourage firms from investing in assets that are not readily realisable, even where such assets would be the best match for their liabilities.
The historic solution to this problem was the concept of the “long-term insurance fund”, which allowed long-term insurers notionally to segregate their long-term insurance business from the rest of their assets and liabilities, and to apply a separate calculation to the long-term insurance fund for the purposes of calculating their distributable profits. Section 843 of the CA 2006 expressly allowed a surplus in a long-term insurance fund to be treated as a realised profit irrespective of whether the assets held in the fund were readily realisable.
This position has now changed for most insurers as a result of the introduction of Solvency II. The Solvency II rules do not refer to a separate long-term insurance fund, and the PRA Rule Book has removed this concept for those insurers who are subject to Solvency II. Hence, section 843 can no longer be relied upon by those insurers (although it will continue to apply for insurers who do not fall within the scope of Solvency II). The Treasury has therefore implemented the Regulations in order to provide a new solution for Solvency II insurers.
Impact of the Regulations
The Regulations set out a series of amendments to Part 23 of the CA 2006, chief amongst which is the introduction of a new section 833A. This provides a formula for calculating the realised profit (or loss) of any given long-term insurer, as follows:
“(4) The formula is “A – L – D“.
- “A” is the total value of the company’s assets;
- “L” is the total value of the company’s liabilities; and
- “D” represents the total value of certain items which the insurer is not permitted to take into account under the Solvency II rules, for the purposes of determining its distributable profits. Examples include: (i) any excess assets over liabilities held within a ring-fenced fund (e.g. a with-profits fund); (ii) any asset representing a surplus in a defined benefit pension scheme; (iii) any liability for deferred tax in respect of certain other specified deductions; (iv) any excess of assets over liabilities held within a matching adjustment portfolio; and (v) amounts representing the capital of the company and other non-distributable reserves.
In each case, the relevant amounts of “A”, “L” and “D” are determined by the values ascribed to them in the company’s balance sheet, prepared in accordance with the remainder of the rules contained in Part 23 of the CA 2006.
It is important to note that reference is made to the value of the assets and liabilities, rather than to realised or realisable amounts, so it is not necessary for assets to be sold or to be readily realisable in order for increases in value to be reflected in the calculation of distributable profits.
Impact on composite insurers
It should be noted that the above formula only applies to insurers to the extent they carry on long-term insurance business. Composite insurers (that is, insurers which carry on both long-term and general insurance business) will therefore need to apply the new provisions to their long-term insurance business, but the other provisions in Part 23 (including the ordinary accounting rules in relation to the value of assets) to their general insurance business. Clearly, this will require some apportionment of assets and liabilities between the two types of business. Section 833A(8) provides that such apportionments must be “just and reasonable;” this provides a certain amount of flexibility for insurers, perhaps tinged though with lingering uncertainty in certain complex cases. To overcome such uncertainty, composite insurers are likely to continue in practice to operate a form of long-term insurance fund, so as to make apportionments on an on-going (and rigorous) basis.
Such a practice will be particularly important for composite insurers who wish to pay interim dividends, rather than relying on final dividends. Interim dividends have the advantage that they can be cancelled at any time up until they are paid, which Solvency II imposes as an eligibility requirement for share capital to be treated as tier one capital, and which final dividends may not satisfy. A composite insurer which operates a form of long-term insurance fund will have more confidence that its interim dividends will be calculated consistently with the Regulations.
Aside from composite insurers, an important difference between the Regulations and the requirements of section 843 is that the Regulations apply to all of the assets and liabilities of the company, with certain exceptions, rather than applying special rules to a particular fund within the company. This should make it easier for insurers to apply the rules, since it will not be necessary to account separately for the long-term insurance fund and for the shareholders’ fund and then combine the two calculations.
The amendments are also consistent with recent tax changes under which tax on long-term insurance business is calculated by reference to the company’s statutory accounts, rather than by reference to the surplus shown in regulatory returns relating to the long-term insurance fund. In combination, the two sets of changes should make the calculation, distribution and taxation of long-term insurance profits more manageable.
Composite insurers will be in a more complex situation, however, and we would expect them in practice to continue to operate a form of long-term insurance fund in order to manage such complexity, even though this is no longer required (or indeed recognised by insurance law and regulation for Solvency II insurers).
The amendments will not apply to those insurers who are outside the scope of Solvency II (for example, due to their small size). Those insurers will still be required to maintain a long-term insurance fund, and will continue to calculate their distributable profits in accordance with section 843 of the CA 2006. Whilst probably inevitable, due to the introduction of Solvency II, the existence of different rules for different types of insurers will result in a greater volume of law and regulation, and likely greater complexity for those operating in the insurance industry.