Solvency II – a process transforming the global insurance industry
The Solvency II Directive is a world-leading standard that requires insurers to focus on managing all of the risks facing their organization. It offers European insurers a real opportunity to improve their risk adjusted performance and operational efficiency, which is likely to be good news for policyholders, for the insurance industry, and the European Union (EU) economy as a whole.
Solvency II is not only on the radar of insurance companies in the EU, but also on those across the globe. The world is watching to see how the EU transforms its insurance industry and implements risk-based improvements to protect policyholders. At the same time, shareholders are also likely to reap benefits. Solvency II is very much a living process and continues to evolve through valuable consultation, feedback, and cooperation between the insurance industry and regulatory bodies. As the process unfolds, unforeseen challenges and opportunities encourage progress and enable adjustments toward achieving the EU’s goals for the insurance industry.
What is Solvency II?
Solvency-II is a European Union legislative programme to be implemented in all 28 member states. It introduces a new, harmonised insurance regulatory regime. Its key objective is to have a uniform policyholder protection across countries through a robust system. This will enable a regime that will have sharper pricing and better allocation of capital, since solvency will be based on the risks.
How does it work?
Under Solvency II, insurers will need enough capital to have 99.5 per cent confidence they could cope with the worst expected losses over a year. The rules take a risk-based approach to regulation: the riskier an insurer’s business, the more precautions it is required to take. “The theory of an economic balance sheet, which better reflects the underlying risks on the balance sheet, is a good one,” says Jeff Davies. The rules have three so-called pillars: the first is quantitative, laying down how much capital the insurers must hold; the second covers internal governance and formal supervision; and the third covers public disclosure and transparency, with the aim that the market will be able to assess (and price) the insurers properly.
The Three Pillars
The European Insurance and Occupational Pensions Authority (EIOPA) defines the three pillars as a way of grouping Solvency II requirements (the concept of pillars is not described in the Directive), which aim to promote capital adequacy, provide greater transparency in the decision-making process, and enhance the supervisory review process—all in the name of good risk management and policyholder protection. This is to be achieved through the implementation of a holistic approach that addresses better risk measurement and management, improves processes and controls, and institutes an enterprise-wide governance and control structure. While Solvency II is split into three pillars, Pillars 2 and 3 are often referred together as Pillar 5 due to the synergies between them.
Pillar 1: Financial Requirements
Pillar 1 covers all the quantitative requirements. This pillar aims to ensure firms are adequately capitalized with risk-based capital. All valuations in this pillar are to be done in a prudent and market-consistent manner. Companies may use either the Standard Formula approach or an internal model approach. The use of internal models will be subject to stringent standards and prior supervisory approval to enable a firm to calculate its regulatory capital requirements using its own internal model.
Pillar 2: Governance & Supervision
Pillar 2 imposes higher standards of risk management and governance within a firm’s organization. This pillar also gives supervisors greater powers to challenge their firms on risk management issues. It includes the Own Risk and Solvency Assessment (ORSA), which requires a firm to undertake its own forward-looking self-assessment of its risks, corresponding capital requirements, and adequacy of capital resources.
Pillar 3: Reporting & Disclosure
Pillar 3 aims for greater levels of transparency for supervisors and the public. There is a private annual report to supervisors, and a public solvency and financial condition report that increases the level of disclosure required by firms. Any current returns will be completely replaced by reports containing core information that firms will have to make to the regulator on a quarterly and annual basis. This ensures that a firm’s overall financial position is better represented and includes more up-to-date information.
Who does well out of it?
Large, diversified groups. First, they have the resources to develop internal models to calculate their capital requirements (rather than using a model created by regulators). These internal models often lead to lower capital requirements. Second, there are capital benefits for diversification, so insurers who do different types of business, and work across borders, come out better than their more specialist rivals.
Who does badly out of it?
Specialist, or insurers do not enjoy any diversification benefits and so may have higher capital requirements. But not all diversification is good. Insurers with large businesses in countries where regulation is not deemed to be “equivalent” to Solvency II may find the new regime more burdensome. Elsewhere, larger insurers will find it easier than smaller ones to cope with the added modelling and reporting requirements that Solvency II creates. Finally, some types of long-term life insurance business, such as annuities, may be less attractive to write under Solvency II rules. Some life companies are reacting by seeking reinsurance deals for longevity risk. Lots of companies that might suffer under the new regime are helped by transitional rules, some of which last for more than 10 years.
KEY WORDS DEFINITION:
Minimum capital requirement (MCR):
Absolute minimum level of capital insurers can hold. Any less, and the company would be insolvent for regulatory purposes. If an insurer gets close to the MCR, it is likely that regulators will step in to run the business.
Solvency capital requirement (SCR):
Amount of capital insurers must hold under new Solvency II regime. Any less, and regulators will become more closely involved.
In conclusion, with Solvency II meeting its objectives of a healthy insurance industry, it is likely to bring with it some business benefits to the insurer through the creation of a framework that consistently reflects economic principles, strong governance and risk management, recognition of diversification benefits, allowance for risk mitigation techniques, risk adequate pricing, and reliance on market mechanisms through increased transparency via public disclosures.
Source: KPMG, Financial Times