Different Brexit scenarios
Even with the recent postponement of Exit Day i.e., the date for Britain's withdrawal from the European Union to—at the latest—October 31, 2019, a No-Deal Brexit1 or a Hard Brexit is not entirely out of the question. This remains the case, even if the EU-UK Withdrawal Agreement is ratified by UK parliament given that the future of a deal for financial services cooperation is still not certain, thus the likelihood of a Hard Brexit as opposed to a customs union or other soft Brexit options still remains likely. This has a number of potential impacts for the insurance and re-insurance sector as explored in this first Client Alert in a special series of "Insurance Insights," which focuses on strategic considerations for (re-)insurers looking to access Germany. This Client Alert also analyzes recent legislative measures of the German policymakers to the current Brexit scenarios. We discuss considerations as they apply to intermediaries in a separate Client Alert in this series.
If "Brexit means Brexit" then "third country means third country"
The EU's single market for insurance was largely driven ahead by the Solvency II Directive. This contains rights on cross-border provision of services or establishment of branches as well as the location of risk concept.2 Upon the UK's exiting the EU, it will become what the EU terms a "third country" for legal and regulatory purposes. Probably the most important consequence of a No-Deal as well as any form of Hard Brexit on the insurance sector is the loss of the European passport for entities looking to access the EU from the UK. Consequently, banks, (re-)insurance companies and investment service providers will no longer be able to provide services from the UK into the EU-27 based on the European passport—a central component of the European financial market. Insurers, re-insurers and their counterparties and clients (including end-users) will want to take note, as without authorization or exemption such third country entity would be breaking the law when attempting to continue to service existing contracts or trying to write new policies. This would also apply to EU-27 exposures written in the UK by an EU authorized insurer operating in the UK.
These concerns remain valid as, despite the delay to Exit Day, many market participants may still be in various degrees of Brexit-proofing both in terms of two separate but interlinked workstreams i.e., the legal entity structuring/market access and the contractual continuity/repapering workstreams. On the legal entity structuring/access work stream, this includes having to decide whether affected firms would rather set up a corresponding business unit in the EU in order to access the market or whether there are any structural solutions such as reverse solicitations or exemptions that can be applied for, to continue conducting new or winding down existing business.
Views of national and European supervisors
Any of those considerations will need to be compliant with the European Supervisory Authorities (ESMA, EBA and notably EIOPA's) supervisory principles on relocations (SPoRs),3which are also complemented by the supervisory expectations and powers of the national competent authorities such as Germany's Federal Financial Supervisory Authority (BaFin). With the amount and varying degree of preparations of affected firms still a work in progress on both sides of the Channel and the Irish Sea, action has also begun at the national legislative level, including Germany, to grant temporary relief.4 It remains to be seen whether these national instruments, which differ amongst EU Member States, may collide with the mandate of EU authorities including powers, which have been granted by EU legislation to EU as opposed to national authorities.
Statistics from 2017 show that insurers coming to Germany from the UK (and Gibraltar) make up the largest proportion of inbound firms (ca. 35 with subsidiaries and 180 with EU passporting services rights) across the EU making use of cross-border access rights, and the UK remains the top destination in the EU for German outbound business. In recent months, the BaFin has received 48 applications from companies looking to relocate to Germany. Some but not all of these are in the insurance sector. There are still companies, which are only now starting to consider the idea of relocating. In the context of these applications, the extent of these entities' ability to operate within the EU is a frequent subject of discussion. The BaFin will not accept the establishment of "empty shells" or "letter box" companies as this would fall foul of the SPoRs and subsequent guidance from the pan-EU supervisory authority, the European Insurance and Occupational Pensions Authority (EIOPA). The German regulator expects the new companies to set-up and maintain certain key functions in the EU-27. This coincides with the expectations set in the SPoRs. One of the European institutions, ESMA, in particular, points repeatedly to this fact.
The European Passport and requirements for third country insurers
One of the core concepts of the EU's Single Market for financial services and thus insurance is the "single license" principle. This permits an EU/EEA insurer to operate in all other EU/EEA Member States, if it has a license granted in one jurisdiction (European Passport). As a result, UK domiciled insurers and re-insurers operating for the period that the UK remains in the EU, may for their part underwrite business in Germany through a branch or by the provision of services in accordance with Section 61(1) of the German Act on the Supervision of Insurance Undertakings (Versicherungsaufsichtsgesetz – VAG) without requiring additional BaFin approval, as they are operating on the premise of the European passport.
For third country insurers, such as the United Kingdom after Brexit, Section 67(1) of the VAG stipulates that a BaFin license is required for business operations in Germany. Conversely, insurers domiciled in Germany would no longer be able to write business in the United Kingdom without further license procedures.
German transitional rules for existing pre-Brexit portfolios
However, it should be noted that the German government introduced certain transitional rules through the German Brexit Act,5 which passed the Bundestag and the Bundesrat and entered into force in Germany on March 29, 2019. This federal law is a German reaction to the pending Brexit scenarios and provides that the United Kingdom may be deemed a continued EU Member State if certain requirements are fulfilled. The key requirement for these transitional rules to apply is that a EU-UK Withdrawal Agreement is neither ratified nor takes effect, i.e. the transitional rules will only apply in case of a No-Deal Brexit. In the event of a No-Deal Brexit, a new Section 66a VAG is intended to enable the BaFin, at its sole discretion, to allow UK insurers who previously operated in Germany under the European Passport to continue their existing business temporarily for a transitional period of not more than 21 months after the UK Exit Date. This temporary period only applies to insurance business, not to MiFID II/MiFIR investment services activities. These services are governed by a different regime with different sets of exemptions and SPoRs.
The German transition period is a purely national and unilateral power granted to the BaFin. It aims to protect German domiciled consumers and policyholders by allowing UK insurers to run-off their German book and terminate contracts with German counterparties or transfer existing contracts to a suitably licensed entity within the EU-27/EEA that has the relevant regulatory permissions to conduct business into Germany. This temporary permission regime, which also has firm specific conditions attached to it, will only be possible for insurance exposures/obligations that were concluded before the UK Exit Date. If no EU-UK Withdrawal Agreement is concluded, the transitional rules under Section 66a VAG will only take effect for existing portfolio business, not for any new business. Any new business either must be discontinued after the UK Exit Date or written by an insurer that has licensed its business operations in the EU-27 (excluding in the UK) and completed its European Passport notifications for Germany. Insuring new business without a new license or managing existing German insurance portfolios outside Section 66a VAG, would be a criminal offence under German law.
New business versus portfolio business
The German transitional rules do not apply to new business. There has been quite some discussion in the market regarding what exactly the "new business" covers. Whilst the recitals in the German Brexit Act clearly state that the transitional rules shall not apply to the "conclusion of new business," they also state that in cases where policyholders have unilateral rights that can be derived from previously concluded contracts, the exercise of such rights shall not be classified as new business. An example of this would be a policyholder's right to extend the term or to increase the sum insured of a policy without further medical examination (example from life insurance). The recitals argue that this position on unilateral rights would be required to enable policyholders to recover claims from UK insurers. The same should hold true for renewal rights where policyholders remain entirely passive and changes are the consequence of a contractual clause expressly agreed prior to the UK-Exit Date.
Market and regulatory developments before and after Germany's transitional rules
Importantly, it remains to be seen whether EIOPA may have its own views on how the BaFin's temporary permissions power fits with its own clear supervisory expectations set out in SPoRs that are notably addressed to the BaFin. EIOPA itself communicated further supervisory expectations as part of its SPoRs at the start of 2019 (see our dedicated coverage from our Eurozone Hub on this.)6 One other area that is of immediate concern is that even if the BaFin were to extend a transitional period, that extension would not apply to intermediary business. Nor would it grant temporary relief from the EU's General Data Protection Regulations (GDPR), as the data transfers from the EU-27 to third countries (UK post Brexit) is a major concern of the GDPR.
In any event, after the expiry of the BaFin transitional period, UK insurers would be treated in accordance with the regulations for third country insurers. This means that they generally will require a subsidiary or branch office in Germany and permission from the BaFin to conduct business. The BaFin, in keeping with the SPoRs, will not grandfather existing permissions but rather will conduct full approval process reviews covering all systems and control frameworks and outsourcing requirements as well as risk-management controls. This review may include a new approval for internal models used in relation to German business. As the BaFin is permitted to consider an application from the point it deems it to be complete for a period not exceeding six months, part of smart forward-planning is to ensure relevant policies and procedures are crafted appropriately to comply with the German rules and the SPoRs, including any fallback arrangements that minimize disruption to clients and markets as a relevant firm transitions to its new post-Brexit operations.
As a result, since 2017, there has been growing movement for UK insurers to set up an insurer as a subsidiary established in the EU or EEA and to operate across the EU/EEA through that subsidiary. Some UK firms have also set-up branches using the European Passport, which upon Exit Day would become third country branches. A third country branch cannot make use of the European passport or conduct business outside the jurisdiction of where it is located. This is one of the reasons why choosing a subsidiary, which has its own EU-27/EEA license and can thus passport, has a number of strategic advantages.
Equally, some UK insurers have partially transferred or are planning to transfer their existing insurance contracts covering risks situated in other EU/EEA countries to the new subsidiary. For insurers based in the EU/EEA countries doing business in the UK, the UK government has also announced that it will create transitional arrangements7 to allow existing contracts to continue for up to three years after Brexit.
One of the key issues that remains unanswered is whether these new powers granted to NCAs such as the BaFin and other EU-27 authorities or measures taken in the UK are compatible with legal principles established at the EU level and potentially may conflict with the pan European mandate of EU authorities. If worst came to worst, such inter-institutional conflicts may lead to confusion, although actions of NCAs only intended to safeguard the interest of policyholders.
Combining market access option with other non-Brexit regulatory exemptions in Germany
So how can UK insurers and reinsurers prepare for both the Section 66a VAG temporary permissions regime as well as the reality post-Brexit? They can either gain market access to individual EU/EEA states based on national regulations, or they may consider using temporary permission regimes as part of national Brexit "emergency" legislation or structural exemptions. Such approach however only allows for the provision of business from the UK or another third country into the target jurisdiction. No European passport is available, and there are likely to be restrictions in relation to conducting new business.The alternative would be to establish or acquire an EU-27/EEA based subsidiary, which will require time, cost and resources.
Insurance undertakings (primary insurers and reinsurers) aiming to conduct inbound business from third countries into Germany must have the appropriate regulatory license to do so. Certain exemptions however are worth noting as these may, irrespective of the Section 66a German temporary permissions regime for pre-Brexit Portfolios, offer some efficiencies.
First, for reinsurance firms looking to conduct business in Germany, the VAG permits an exemption to those carrying out solely reinsurance business in Germany from the requirement for authorization from the BaFin or the establishment of a branch office, if the third country's solvency regimes for reinsurance activities carried out by firms in the relevant country are considered to be "equivalent" to those of the Solvency II Directive. The European Commission is the arbiter of those equivalence decisions, which are discretionary and may be withdrawn at any time in the event the UK diverges from the EU's Solvency II regime.
Second, one other structural exemption which may be available for non-retail policyholders and which is based on the very German regulatory principle of "insurance by correspondence" (Korrespondenzversicherung) will not trigger a VAG authorization requirement. This exemption will be available in circumstances where reinsurance business is requested by a prospective policyholder domiciled in Germany. This German regulatory principle operates on the premise that a contract is concluded by correspondence with a non-German primary insurer or reinsurer without one of the parties being assisted by a professional intermediary in Germany or a professional intermediary domiciled abroad but acting as intermediary in Germany. A (re-)insurance provider will want to ensure it can evidence documented trails of that request.
In summary, regardless of where firms are at in their Brexit-proofing considerations, they will want to periodically consider the amount and feasibility of new versus existing/run-off business, the nature of policyholders, as well as how to ensure any existing set-ups can optimize relevant temporary and/or on-going exemptions, while equally considering how current and any new post-Brexit EU-27 legal entity as well as contractual solutions can be SPoR compliant. Equally, firms will want to ensure that policies, procedures and key functions also meet the requirements set by the BaFin for German business as well as more generally the requirements of EIOPA.
What is clear is that (re-)insurance businesses should not treat any Brexit delay, any EU-27 actions or German and UK transition periods as more than a breathing space, particularly in light of the fact that the transition period is dependent on the course taken in relation to the EU-UK Withdrawal Agreement itself. This is especially the case for those looking to maintain a presence in both the UK and the EU. Supervisors at the EU and national level continue to emphasize that businesses need to continue to prepare to make authorization applications and begin insurance business transfer processes as soon as possible.
1 It is important to note that the German Federal Government and the German media rather confusingly refer to a "Hard Brexit" the same as a "No Deal" Brexit.
2 It is important to note that, Solvency II sets out the basic rules on determining the location of risk, although these may be subject to local law interpretation. Solvency II provides that buildings and contents cover will be determined by the location of the property; vehicle cover is determined by the state of registration; short-term holiday cover is determined by the location where the policyholder took out that cover, and all other policies will be determined by place of residence/establishment of the policyholder.
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