Overview

Solvency II will radically change the supervision of insurers and reinsurers across Europe. Under the Solvency II Framework Directive, existing insurance directives will be amended and recast into the new regime which aims to introduce a consistent, risk-based, solvency regime which better reflects modern solvency and reporting requirements.

The Solvency II Framework Directive, which was adopted by the European Council on 10 November 2009, requires the provisions of the new regime to be in force by the end of October 2012.

Background to Solvency II

During 2004 and 2005 the European Commission undertook a review of EU insurance law in order to improve consumer protection, modernise supervision, deepen market integration and increase the international competitiveness of European insurers and reinsurers. Under Solvency II insurers will be required to take account of all types of risk to which they are exposed and to manage those risks more effectively.

The current solvency system is over 30 years old and financial markets have developed significantly since then, leading to a large discrepancy between the reality of the insurance business today and its regulation. The reforms have been driven forward as a consequence of the European Commission concluding that there are widespread divergences in the implementation of the existing insurance directives across the EU and ensuring that the insurance sector has a comparable regulatory and prudential regime to that of the banking and securities sectors in the EU.

Solvency rules stipulate the minimum amounts of financial resources that insurers and reinsurers must have in order to cover the risks to which they are exposed. The rules also lay down the principles that should guide insurers' overall risk management so that they can anticipate any adverse events and handle such situations more effectively.

The new solvency requirements have been designed to ensure that insurers have sufficient capital to withstand adverse events, both in terms of insurance risk (as under the previous regime), and now also in terms of economic, market and operational risk.

Solvency II is to be adopted in accordance with the “Lamfalussy” process. The Lamfalussy process takes a four-stage approach to the introduction of financial services regulation. In the first stage a framework directive is proposed (after a full consultation process). At stage two technical implementing measures are introduced; much of the detail is added at this stage. The third stage involves work on recommended guidance and non-binding standards which are not included in the legislation. Finally, the fourth stage of the process requires the Commission to monitor compliance by Member States.

How is Solvency II structured?

Solvency II will be based on a “three pillar” framework. The pillar system originates from the approach taken in the Capital Requirements Directive, which followed the international Basel II Accord for banks and investment firms.

Pillar 1 – minimum capital requirements

Under the first pillar insurers are required to maintain reserves against liabilities (technical provisions). A consistent market-based system is applied for assessing liabilities as well as ensuring a greater matching of assets to liabilities. Insurers and reinsurers must adhere to a Minimum Capital Requirement (MCR), which is the fundamental level of solvency required of any insurer. This has been set at an absolute floor of €2,200,000 for non-life and €3,200,000 for both reinsurance and life insurance undertakings. If the MCR is breached, supervisory action will be taken.

The Solvency Capital Requirement (SCR) represents the target level of solvency which an insurer or reinsurer needs to maintain. It is a fully risk-based calculation which can be made either through a standard formula or by using internal models (or a combination of both). Basically the SCR is the amount of capital needed to leave a less than 1 in 200 chance of capital being inadequate over the forthcoming year.

The Directive requires that insurers and reinsurers invest their assets in accordance with the “prudent person” principle and should invest in such a manner as to “ensure the security, quality, liquidity and profitability of the portfolio as a whole”.

Pillar 2 – supervision of risk

Insurers will be required to submit their own assessment of risk and solvency capital adequacy (known as the ORSA). In addition, they must submit details of their internal systems and controls. The internal risk and capital review process is subject to a regulatory supervision process akin to that introduced by the FSA in the “ICA” regime.

Should it be seen to be necessary, supervisors may add a “capital add-on”. It might be that the supervisor will request that further capital be injected into the SCR following the review process, although this should only occur when the supervisory authority concludes that the risk-profile of the insurer “deviates significantly” from the assumptions underlying the SCR.

Pillar 3 – public disclosure

The third pillar harmonises disclosure requirements. Insurers are required to report publicly on their financial condition, providing information on capital.

Please click here to view table.

Key points

  • The new solvency regime will be risk-based and is an evolution of the FSA’s current regime.
  • Insurers will be required to satisfy a Minimum Capital Requirement (MCR) and to run their business in such a way as to also satisfy a higher capital requirement, the Solvency Capital Requirement (SCR). Breach of the MCR is designed to lead to the loss of the insurer’s licence, whereas breach of the SCR will trigger regulatory intervention in order to resolve the breach.
  • The SCR will be calculated using either a standard formula or a bespoke “internal” model, or in some circumstances, a partial internal model together with the other components of the standard formula. The risks to be covered by “modules” of the model include underwriting risk, market risk, credit risk and operational risk. Internal models will need to be “used” to manage the business and approved by the relevant supervisor. This is likely to require documentation of a high standard which enables the model to be properly understood. Internal models will not, however, be subject to a separate external audit.
  • Groups will need to calculate a group solvency capital requirement (Group SCR). This can produce a lower group requirement than the aggregate of the individual members’ own requirements. Individual members of the group must still comply with their own “solo” requirements but any surplus arising only at the group level (eg, because of any diversification benefits) may be treated as additional capital for the individual group members. In addition, there are also capital instruments (eg, hybrid capital and subordinated liabilities) which will count towards the solo SCR but not the Group SCR.
  • Insurers will be subject to requirements to have adequate governance arrangements in place, including risk management, audit, actuarial and compliance functions. The risk management function will be responsible for the design, implementation and validation of any internal model.
  • Insurers will have to produce an “Own Risk and Solvency Assessment” (ORSA). This is the insurer’s own risk based assessment of its solvency position and may reflect areas where, for example, the standard formula is not appropriate for the insurer. It is different from the ICA (which is the FSA’s current risk based assessment that sits on top of the formulaic EU minimum requirements) in that most of the risk based assessment of capital should be built into the MCR and SCR calculations.
  • Supervisors have the right to require “capital add-ons”, which after a potential five year initial transitional period, will be made public. This right is however limited to areas where the risk profile is not in line with that in the SCR or there are “significant governance deficiencies”. The right is also supposed to be used only in “exceptional circumstances”.
  • One of the fundamental changes in Solvency II is the move to a market consistent valuation of liabilities (on the basis that your capital will never be assessed properly if you do not have a realistic view of your liabilities). In broad terms this means that you should value your liabilities based on expected future cash flows, discounted appropriately and, unless you can find a hedge for your liabilities, you must hold a “risk margin” to reflect the cost of capital that would be required to transfer the liabilities to a third party. As part of this process there will also be new rules on how to treat reinsurance and other risk mitigation techniques.
  • The Directive also includes rules on how insurers’ capital requirements can be satisfied. Capital held, known as “Own Funds”, is either Basic Own Funds (what an insurer has on the balance sheet, eg, the excess of assets over liabilities plus subordinated liabilities) or Ancillary Own Funds (what an insurer may be able to call upon if needed, eg, unpaid capital, letters of credit, guarantees and other legally binding commitments). Ancillary Own Funds can only be used as capital with the approval of the supervisor. In addition, Own Funds are divided into 3 tiers to reflect their permanence and ability to absorb losses. The MCR cannot be covered by Tier 3 Own Funds or Ancillary Own Funds. It is currently proposed that at least 50 per cent of capital held to cover the SCR needs to be Tier 1 (with the highest level of permanence and loss absorbency) and that no more than 15 per cent can be held as Tier 3.
  • Although the Directive does not contain the group support provisions that would have enabled the SCR to be held at group level (with just the MCR held at individual insurer level), it contains provisions that mean that this topic must be reviewed 3 years after implementation (ie, in 2015).
  • The Directive also includes provisions for more detailed public disclosure of an insurer’s management of its business and capital in the form of a “Solvency and Financial Condition Report” (SFCR) including a summary written for the benefit of policyholders.

Please click here to view diagram.

Where are we now?

The legislative process

  • The Level 1 Framework Directive was adopted by the European Council in November 2010 and has been published in the Official Journal of the European Union.
  • The Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) has delivered advice on all Level 2 measures to the European Commission, including the last outstanding papers in respect of the criteria for assessing the equivalence of third countries and the final calibration of the non-life and health underwriting modules of the standard formula and the calibration of the MCR.
  • CEIOPS has also delivered to the European Commission the report of the liquidity premium task force.
  • The European Commission is currently drafting the Level 2 implementing measures of the Directive, following advice from CEIOPS. The Commission is in discussion with various stakeholders including the various Ministries of Finance of Member States in additional to members of the insurance industry. There will be no public consultation of the Level 2 measures but a public meeting has been convened for 4 May 2010.
  • The Commission will formerly adopt proposals for the Level 2 measures in the autumn of 2010. The measures will then be discussed by the European Insurance and Occupational Pensions Committee, the European Council and the European Parliament. The usual voting is reserved, so a qualified majority vote would be required to defeat the proposals. Final adoption of the Level 2 measures is expected around October 2011.
  • CEIOPS is working on the Level 3 guidance which the European Commission have requested to be delivered by December 2011. CEIOPS published their first Level 3 guidance on 31 March 2010 on the pre-application process for firms’ internal models.
  • Recent indications suggest that the final implementation date may be delayed until 1 January 2013. This would require an amendment to the Level 1 Framework Directive, and would be achieved through the expected Omnibus II Directive.

QIS5

  • CEIOPS has run a series of quantitative impact studies (QIS) to gain insight into how the proposals under the Solvency II regime will impact insurers’ balance sheets. These QIS studies help to guide the Commission on the best possible approaches for implementation and to assess the financial impact and practicality of the Level 2 proposals.
  • The European Commission published for consultation draft technical specifications for QIS5 on 15 April 2010. The draft technical specifications differ from those proposed by CEIOPS in what has been seen as a concession by the Commission to industry concerns about the potential impact of proposals on firms’ capital requirements. The final technical specifications will be published in June 2010.
  • CEIOPS will run the QIS5 exercise from August to November 2010. Results are expected to be published in April 2011.
  • Solo undertakings will be required to complete QIS5 by the end of October, insurance groups by mid November.

Solvency II useful links

The Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS)

CEIOPS Level 2 advice to the European Commission

The European Commission

Solvency II Level 1 Directive (in the various languages of Member States)