The UK Prudential Regulation Authority (“PRA”) has issued its final Supervisory Statement on the remuneration rules of Solvency II, setting out the PRA's expectations as to how insurance firms are required to comply with these new rules.

The Solvency II rules on remuneration form part of the new governance framework for insurers which took effect from the beginning of this year. The remuneration rules are set out in Article 275 of the Solvency II Level 2 Delegated Regulation (the "Delegated Regulation") and are directly applicable in the UK. Whilst the remuneration rules have been in force since 1 January, the PRA Supervisory Statement now provides detail as to what action firms are expected to take to ensure compliance.

The remuneration of employees in the insurance industry has largely escaped the scrutiny (and, criticism) experienced by other parts of the financial sector since 2010, which faced increasingly onerous regulation of their approach to remuneration. This has been reflected in the remuneration rules of the third, then fourth, capital requirements directives (CRDIII and CRDIV) applicable to the banking sector and the Alternative Investment Fund Managers Directive (AIFMD) and the UCITS V directive applicable to the asset management sector.

Whilst the Solvency II remuneration rules impose a less onerous regulatory burden than these other directives, the PRA's Supervisory Statement reflects a more rigorous interpretation of the rules by the PRA than may have been expected.

As with the requirements applicable to banks and investment firms under CRD IV, the Solvency II remuneration rules comprise: (1) rules in respect of the governance and oversight of remuneration decisions; (2) general requirements as to the content of a firm's remuneration policy with the aim of ensuring that remuneration adequately reflects risk; and (3) specific rules governing the structure of individual staff members' remuneration referred to as the "Pay Out Process Rules."

The Pay Out Process Rules are the highest profile requirements, and apply in respect of the variable remuneration awarded to those categories of staff that are judged to have a material impact on the risk profile of the insurance firm (referred to as "Solvency II Staff"). In its Supervisory Statement, the PRA states that for insurance firms in PRA Categories 1 and 2 the Pay Out Process Rules require that 40% of bonuses for Solvency II Staff must be deferred over at least three years, and that the firm must have the ability to operate negative, risk-based adjustments (or "malus") in respect of such awards. 

Although less eye-catching than the Pay Out Process Rules, the requirements of Solvency II relating to the process for determining bonus awards, and ensuring that awards are adjusted to take into account risk, can be seen as best representing the overriding aim of the Solvency II remuneration requirements. In our experience, whilst in the early days of these regulatory regimes the regulatory focus appeared to be on the Pay Out Process Rules, there is now a very clear focus from the regulators on the need to ensure robust risk-adjustment processes are in place. 

Our briefing reviews the Solvency II remuneration rules, and the final PRA Statement, in detail, and draws on our experience in advising banks, building societies and asset managers in respect of similar regimes to discuss the practical issues which insurers and reinsurers will face in complying with these requirements.

This post comes to us from Herbert Smith Freehills LLP. It has been authored by Bradley Richardson and Mark Ife.