Solvency II is the updated set of regulatory requirements for insurance firms that operate in the European Union. It is scheduled to come into effect on 1 January 2013. FSA's website states that the EU directive is due to be implemented on 1 November 2012.
The rationale for European Union insurance legislation is to facilitate the development of a Single Market in insurance services in Europe, whilst at the same time securing an adequate level of consumer protection. The third-generation Insurance Directives established an "EU passport" (single licence) for insurers based on the concept of minimum harmonisation and mutual recognition. Many Member States have concluded that the current EU minimum requirements are not sufficient and have implemented their own reforms, thus leading to a situation where there is a patchwork of regulatory requirements across the EU. This hampers the functioning of the Single Market.
Solvency II will be based on economic principles for the measurement of assets and liabilities. It will also be a risk-based system as risk will be measured on consistent principles and capital requirements will depend directly on this. While the Solvency I Directive was aimed at revising and updating the current EU Solvency regime, Solvency II has a much wider scope.
A solvency capital requirement may have the following purposes:
- To reduce the risk that an insurer would be unable to meet claims;
- To reduce the losses suffered by policyholders in the event that a firm is unable to meet all claims fully;
- To provide early warning to supervisors so that they can intervene promptly if capital falls below the required level; and
- To promote confidence in the financial stability of the insurance sector
Often called "Basel for insurers," Solvency II is somewhat similar to the banking regulations of Basel II. For example, the proposed Solvency II framework has three main areas (pillars):
- Pillar 1 consists of the quantitative requirements (for example, the amount of capital an insurer should hold).
- Pillar 2 sets out requirements for the governance and risk management of insurers, as well as for the effective supervision of insurers.
- Pillar 3 focuses on disclosure and transparency requirements.
The Solvency II regime offers incentives, potentially in the form of reduced capital requirements, to implement appropriate risk management systems and sound internal controls. As in Basel II for Banking, the regime has a three pillar structure, with each pillar governing a different aspect of the Solvency II requirements and approach: Quantitative Requirements; Supervisor Review; and Market Discipline. As well as requiring firms to disclose their capital and risk frameworks, the Directive also asks firms to demonstrate how and where the requirements are embedded in their wider activities.
Forward planning for capital adequacy and risk management will become a part of any new strategic venture but the ‘embedding’ requirements as part of business as usual will also affect hedging and reinsurance strategies, product development and pricing, underwriting and investment management. Responding adequately to these new requirements will mean a major shift in thinking for many organisations – and a rigorous and planned approach to bridge the gap between standards now and those required for 2012.
Pillar 1 considers the quantitative requirements of the system, including the calculation of technical provisions, the rules relating to the calculation of the solvency capital requirements and investment management. Pillar 1 sets out a valuation standard for liabilities to policyholders and the capital requirements firms will be required to meet. There will be two Solvency requirements - the Minimum Capital Requirements (MCR) and the Solvency Capital Requirements (SCR). If the available capital lies between the SCR and the MCR, it is an early indicator to the supervisor and the insurance company that action needs to be taken. An insurance company can choose whether to calculate the SCR using a standard formula set down by the regulator or whether to develop its own internal model to reflect the specific risks the organisation faces. If the later approach is adopted the insurer needs to gain approval from the supervisor.
Pillar 2 deals with the qualitive aspects of a company's internal controls, risk management process and the approach to supervisory review. Pillar 2 includes the Own Risk and Solvency Assessment (ORSA) and the Supervisory Review Process (SRP). Irrespective of whether a firm adopts the standard formula or internal model under Pillar 1 it has to produce an ORSA. If supervisors are dissatisfied with a company's assessment of the risk-based capital or the quality of the risk management arrangements under the SRP they will have the power to impose higher capital requirements.
Pillar 3 is concerned with enhancing disclosure requirements in order to increase market transparency. Companies must interpret the disclosure requirements, develop a strategy for disclosure and educate key stakeholders on the potential impact. The onus is placed on firms to design the information which, through public disclosure, will be available to regulators, analysts, rating agencies and shareholders. In addition, organisations must also develop the internal processes and systems to produce these reports.