Frequently Asked Questions

Solvency II – Frequently Asked Questions

 • What is Solvency II?

Solvency II is the name of the new European Directive for insurers covering their capital requirements and related supervision. It is expected to come into effect on 01 January 2013. Solvency II will replace a series of existing European Directives, some dating back to the 1970s and will overtake a number of requirements currently imposed by individual national regulators. Solvency II is set to introduce a more modern, risk-based approach using market consistent methods for the valuation of insurers’ assets and liabilities. This means wherever possible actual market prices are used. Where these are not available market-based techniques are used, to establish what a fair price would be for the sale of an asset or liability between a willing buyer and seller. This would include an economic assessment of the value of all options and guarantees provided in any insurance contracts. Taken together, the promised reforms should deliver a more proportionate regime of supervision, with risks properly identified and capital matched accurately to mitigate these risks. Solvency II should also see a much greater consistency in the supervision of insurance firms across Europe.

 

• What are the key dates for the development and implementation Solvency II?

The European Commission approved the final Level 1 Directive in April 2009. Whilst the Directive will set out the overall framework for Solvency II, many of the detailed requirements are set out in ‘implementing measures’ which are being developed in parallel by the Commission under the Lamfalussy process. An extensive consultation process is being undertaken by the European Commission and the Committee of European Insurance and Occupations Pension Scheme Supervisors (CEIOPS) to seek stakeholders’ views in developing the Solvency II Directive. The Commission issued a framework for consultation including three waves of ‘calls for advice’, upon which CEIOPS issued consultation papers and subsequently provided advice to the Commission. In January 2010, CEIOPS issued their final advice for Level 2 implementing measures on Solvency II. The Commission is expected to formally adopt proposals for Level 2 implementing measures by the end of 2010. Another important part of this process will be the fifth Quantitative Impact Study (QIS5), which will run from 1 August to 30 October (mid-November for groups). The results of this exercise will provide a significant input into the final calibration of the Solvency II requirements.

 

• What is the ‘Lamfalussy process’ and how will it affect the Solvency II Directive?

The Lamfalussy process has been adopted by the European Parliament as a more flexible basis on which to develop and implement new legislation. Lamfalussy provides a mechanism to update the detailed specifications in a Directive such as Solvency II, as market conditions and other circumstances change, whilst securing the principles and key requirements in primary legislation. The Parliament also retains a right to ‘call-back’ the legislation if it wishes to review the implementation or revise the effect of the legislation it has passed in the light of experience. In essence, Lamfalussy introduces a four-level regime;

Level 1 - Primary legislation defining broad ‘framework principles’.

Level 2 - Technical implementing measures to be adopted by the Commission.

Level 3 - Working arrangements and common practice agreed amongst national supervisors to ensure consistent application of Level 1 and Level 2 measures.

Level 4 – Enforcement by the Commission to ensure consistent implementation of EU legislation

 

• What are ‘MCR’ and ‘SCR’ under Solvency II

These are the two key control levels for capital assessment. The SCR is the Solvency Capital Requirement. It is the normal, target level of capital an insurer will be expected to hold. It will be calibrated to enable the insurer to withstand a single 1-in-200 year negative event and still meet all its liabilities to policyholders. Where an insurer’s capital reserves fall below the SCR level, this is likely to trigger supervisory intervention. The cause and extent of the breach and the speed at which the insurer’s capital position has deteriorated will influence the nature and degree of action taken by the supervisor. The MCR is the Minimum Capital Requirement. This is the absolute minimum level of capital that an insurer must hold at all times. If the insurer were to fall below this level of capital, this would trigger the most extreme supervisory intervention. Typically, the firm would then be prevented from writing new business and the regulator may initiate proceedings to wind up the company and transfer its insurance assets and liabilities.

 

• What are Pillar 1, and Pillar 2 and Pillar 3?

The new framework of regulation under Solvency II will consist of three pillars, covering internal risk and capital assessment, qualitative review and external disclosure. These are described more fully below:

Pillar 1 comprises the main quantitative capital assessment process, which will produce a calculation of the amount of capital a firm needs to hold to mitigate its risks. Firms can undertake this assessment either by using their own internal model, or by using the ‘standard approach’ provided for in the Solvency II Directive.

Pillar 2 is a qualitative assessment process undertaken by the supervisor. At this stage the supervisor reviews the firm’s Pillar 1 capital assessment and considers whether there are any risks or factors that have not already been fully captured in the firm’s own capital assessment. The supervisor will also assess the firm’s systems and controls and other governance related issues as part of the Pillar 2 assessment.

Pillar 3 refers to the public disclosure of information, including regulatory returns and other data suitable for publication, to help the markets, investors and policyholders better understand the nature of the business of each insurer. This provides a separate and important discipline. The intention is to build on existing publications where possible and only require additional disclosures as a form of ‘top-up’, to avoid unnecessary duplication. However, there is no certainty that an alignment will be achieved between the requirements of Solvency II and international accounting standards

 

Consumers

• What will be the benefit of Solvency II for consumers?

Solvency II will reduce the risk of failure or default by an insurer, with improved identification, understanding and monitoring of risk across Europe. Risks will be more clearly identified and action taken more quickly to address problems as they arise – particularly unplanned or unexpected events. A more consistent and open regulatory framework should make it easier for companies to sell across different markets, promoting competition; whilst more sophisticated assessment of insurers’ capital requirements should mean they are no longer required to hold excess capital, which increases costs and makes insurance and investment contracts more expensive than they need to be.

Removing arbitrary restrictions, such as those on investment strategy or product design should also enable insurers to provide a broader range of products to consumers that can better match their individual requirements.

  

Insurers

• What will be the benefits of Solvency II for insurers?

Solvency II should bring a number of benefits for insurers. The new regime will have a much greater focus on risk assessment and transparency, rather than arbitrary restrictions and unmeasured prudence. Market-based valuation of assets and liabilities will improve transparency and enable both firms and supervisors to better understand the underlying financial position of the insurer. Solvency II will also see a much greater role for firms’ own internal risk and capital assessments, including their own internal capital model, to provide a significant input to the supervisor’s assessment of the firm. A more streamlined and proportionate regulatory regime should reduce burdens on insurers, reducing costs and increasing flexibility. Furthermore, the alignment of or regulatory quantitative requirements with the true economic cost of risks will lead to an improved international competitiveness of EU insurers.

 

• How will smaller insurers be treated under Solvency II?

Solvency II will recognise the needs of smaller insurers in a number of ways: First, the current exemptions under Solvency I for the smallest insurers are expected to be carried over to Solvency II, meaning that the existing, local arrangements for the supervision of the smallest entities can continue under Solvency II. Second, there will be a ‘standard approach’ for the calculation of the ‘Solvency Capital Requirement. This will provide a framework enabling small companies without their own models to undertake the required solvency calculations using more elementary data which they will already have available.

A key principle underlying Solvency II is proportionality, so the requirements imposed on a company will reflect the risks they pose and can better recognise the particular circumstances of each firm.

  

• Will Solvency II accelerate consolidation in the market?

Solvency II is not seeking to impose a single structure on the market, instead the nature and organisation of insurers should be driven by economic logic. Solvency II will not stop an established trend toward consolidation, but equally companies who specialise and manage their risks effectively should also prosper under Solvency II.

 

• How will mutual insurance companies be treated under Solvency II?

The Solvency II consultation process includes consideration of the particular circumstances of mutuals, looking at member calls and their contribution to the capital strength of the insurer. The interests of smaller and specialist insurers, many of whom are mutuals, have also featured in the consultation process.

 

• What is an ‘internal capital model’?

Many insurers will have a model, typically a sophisticated computer-based system to forecast the future pattern of cash-flows using a framework of financial and economic assumptions. These models will normally provide a projection of the changes to the value of assets and liabilities at different future dates using a series of assumptions set by the firm. Typically, the model will allow a range of different scenarios (including disaster scenarios) to be applied to assess the effect on the value of assets and liabilities. One of the aims of an internal capital model is to determine the appropriate level of capital of a firms. The development and use of an internal capital model is usually aligned with the more general risk modelling work undertaken by firms to document, describe and understand the risks in their business, the factors that affect these risks and the tools they can use to mitigate these risks.

 

 Regulatory

• What are the benefits for regulators?

Regulators will have a better understanding of the firms they are regulating. The information they receive will more clearly identify the key risks in the business. This will ensure supervisors can take earlier action where risks emerge, which should reduce the risk of failure and enable them to concentrate their efforts on those firms and those areas where there is the greatest risk to consumers and to the financial system generally.