The project to implement new solvency standards in the EU, known as Solvency II (previously discussed in the December 2006 issue (No. 62) and the September 2007 issue (No. 65) of Kendall Freeman’s Insurance Review) is now reaching an important phase. This article provides an overview of the Solvency II project to date and the work that needs to be done to achieve implementation by 2012. We also look at the formation of the rules that will underpin the new directive, including the most recent Quantitative Impact Study (QIS). Finally, we briefly examine the proposals for one of the most controversial elements of Solvency II – group supervision.

The Solvency II Directive

Solvency II was envisaged even before the Solvency I regime came into force in 2004. The Solvency I rules, found in Directives 2002/83/EC (for life assurers) and 2002/13/EC (for non-life insurers), contained a requirement for the European Commission to submit a report to the European Parliament and Council on the need for further harmonisation of solvency rules by the start of 2007. The need for such further reforms was highlighted by the fact that many EU states, including the UK, had implemented solvency standards that went beyond Solvency I. This lead to patchwork regulation, impeding the free market ideals that operate throughout the EU for (re)insurers. Immediately after Solvency I came into force, work therefore began on Solvency II.

The formal proposal for a Solvency II directive was first published on 10 July 2007 (the Directive). This anticipated the consolidation of 13 existing insurance and reinsurance directives and the new solvency provisions. However, discrepancies arose between the Directive and the other directives being consolidated as a result of amendments made to certain provisions, eg the assessment of acquisitions and increase of holdings in the financial sector (made by Directive 2007/44/EC). Further, the provisions of the Directive were affected by an agreement on the law applicable to contractual obligations (the draft Rome I Regulation). This meant that changes were required to the original proposals and the Directive was republished on 26 February 2008.

The Directive consists of a three pillar structure. Each is explained below:

  • Pillar One comprises the quantitative require-ments including calculation of the solvency capital and minimum capital requirement. The solvency capital requirement is established through a risk based approach. This is a fundamental change from the previous solvency rules and will give a more accurate allocation of capital to risk. The Directive also provides for (re)insurers to calculate the solvency capital requirement using their own internal models, subject to regulatory approval.
  • Pillar Two focuses on the qualitative require-ments such as the supervisory review process.
  • Pillar Three encompasses supervisory reporting and disclosure requirements.

Timetable to Implementation

At this stage, the Directive is simply a proposal made by the European Commission. For this to pass into EU law, the Directive must be adopted by both the European Parliament and the Council. This is expected to occur in 2009. A legislative mechanism known as the Lamfalussy model is being used to bring the Solvency II proposals into EU law pursuant to various levels of measures. The Directive equates to the level 1 measures under the Lamfalussy model as it consists of the core principles and the implementing powers. More detailed rules (the level 2 measures) will also need to be adopted by the European Commission following advice from the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS). CEIOPS has so far carried out four QISs to assist in the formation of this advice to the European Commission. CEIOPS is due to deliver its report of the latest of these, QIS4, in November 2008. The results of QIS3 and the contents of QIS4 are discussed in greater detail below.

The development of the level 2 measures will take another two years, with formal adoption by the European Commission expected in 2011. This will give sufficient time for translation of the Directive into EU states’ national law by 2012.

QIS3 and QIS4

The final report on QIS3 was published by CEIOPS in November 2007. The report concluded that of those (re)insurers who participated, the vast majority (98%) would not need additional capital to meet the minimum capital requirement anticipated by the Directive. When looking at the European market as a whole, CEIOPS concluded that although no additional capital was required, the move towards a risk based system meant that a redistribution of capital would need to take place. QIS3 also offered the first opportunity in the Solvency II project to evaluate group solvency. However, the results were of limited value due to the small number of groups who participated in QIS3 and internal model results that were provided.

QIS4 was another opportunity for (re)insurers, including groups, to evaluate their solvency position under the proposed Solvency II rules. It was divided into six sections namely the valuation of assets and liabilities, own funds, solvency capital requirements based on a standard formula, solvency capital requirements based on internal models, minimum capital requirements and groups. As well as the expected aims of collecting data for advising on the formulation of the implementing measures, the European Commission stated that QIS4 should also “encourage insurers, reinsurers and supervisors to start preparing for the introduction of Solvency II and to identify areas where their internal processes, procedures and infra-structure may need to be enhanced”. With this in mind, as well as the need to collate more data from groups following QIS3, the European Commission sought an ambitious participation rate of 25% of solo (or individual) entities and 60% of (re)insurance groups across the EU. Particular emphasis was placed on obtaining submissions from small and medium sized (re)insurers. The deadlines for submissions were 7 July 2008 (for solo entities) and 31 July 2008 (for groups).

Group Supervision

The Directive sets out key provisions relating to the supervision of (re)insurance groups in the EU. The current insurance and reinsurance directives merely add on group supervision elements to the core solo entity supervision provisions. The Directive recognises that group supervision is fundamental and that many provisions “will directly influence the way in which solo supervision is carried out on entities belonging to a group”.

The key group supervision provisions are:

  • A Group Supervisor – each (re)insurance group will have a single authority appointed to oversee the regulation of the entire group. This group supervisor will exercise its responsibility in cooperation and consultation with local supervisors of any sub-groups concerned.
  • Efficient Supervision – supervisors are required to exchange information automatically or on request (depending on the nature of the information) and to consult each other prior to important decisions.
  • Supervision of Sub-Groups – there will be a maximum of three levels of supervision (the EU group, national sub-groups and solo entities).
  • Group Solvency – under the proposal, a (re)insurance group will be able to apply for permission to use internal models for the calculation of the group solvency capital requirement.

Countdown to 2012

The Solvency II project will reach a major milestone when the Directive is adopted next year. However, there still remain significant questions over how it will work in practice. A lot of work is therefore required before 2012. Input is already being obtained from across the insurance industry as to how to improve the proposal to ensure not only that it can work in practice, but also that maximum benefit is obtained from the project. The level 2 implementing measures need to be developed and refined, and the new rules transposed into national laws across the EU. Regulators need to prepare for, amongst other changes, the new approach to group supervision and the increased requirement to co-operate and consult with each other. (Re)insurers, especially groups, also have an important part to play in these processes by providing input to regulators, CEIOPS and the European Commission whenever possible. The implications of the Directive on their business should also be considered so that its benefits can be fully utilised by each (re)insurer.