This briefing note is intended to give a short overview of the Solvency II Directive which will introduce a framework for a new EU capital adequacy and supervisory regime for the insurance sector.
Solvency II is intended to create a more risk-based system of supervision for firms carrying on insurance business. It represents a fundamental shift in the approach to regulation of the insurance industry and is intended to fully harmonise regulation across the EU while at the same time imposing much stricter requirements on firms to protect policy holders.
The new regime will apply to all insurance firms with gross premium income exceeding EUR 5m or gross technical provisions – the amount set aside in reserve to fulfil a firm’s insurance obligations - in excess of EUR 25m. This threshold catches almost all EU insurers and reinsurers and the Prudential Regulation Authority (PRA) has advised that 400-450 UK firms will be caught.
The implementation of Solvency II has been subject to lengthy delays but it will finally come into force on 1 January 2016.
Solvency II Framework
Often referred to as "Basel for insurance", after the capital adequacy requirements for banks, the requirements of Solvency II are in some ways quite similar to the banking regulations. For example, the Solvency II framework has been grouped into three separate "pillars":
- Pillar 1 – which deals with capital adequacy;
- Pillar 2 – covering systems of governance and risk management; and
- Pillar 3 – which deals with supervisory reporting and public disclosure.
Pillar 1 – Capital adequacy
Pillar 1 contains the key quantitative requirements which a firm needs to demonstrate it has in order to be considered solvent and adequately capitalised to deliver policy holder protection. This must be done through both the holding of reserves and the calculation of regulatory capital.
The quantitative requirements imposed by Solvency II fall under two main headings – "technical provisions" and what is referred to as "own funds", or as most people would call it, regulatory capital.
Firms are required to establish "technical provisions", the holding of reserves to cover all of their expected future insurance and reinsurance liabilities. The level of technical provisions needed are based on the capital another firm would require to take over the insurance obligations of a firm.
Own funds are divided between "basic own funds" and "ancillary own funds". The two categories are then further divided between three tiers, with Tier 1 being the most robust and Tier 3 the least.
Firms must also have capital to cover both the minimum capital requirement (MCR) and the solvency capital requirement (SCR), which must be made up of own funds.
The MCR is the level of capital below which an insurance firm will be deemed to be insolvent for regulatory purposes. It must be calculated quarterly in accordance with a standard formula set by the Financial Conduct Authority (FCA) on a "value at risk" measure which is intended to reflect the risk associated with a portfolio of assets and liabilities. The capital here must come from Tiers 1 and 2 of their basic own funds.
The European Commission describes the SCR as the key solvency control level which gives a more flexible and risk sensitive standard than the MCR. The SCR should demonstrate a level of own funds that would enable a firm to absorb significant losses and still pay monies that are due to policy holders. The intention is for the SCR to reflect the real risk profile of a firm, taking into account insurance risk alongside market risk, credit risk and operational risk.
The way in which the SCR is calculated is similar to the MCR, but calibrated to a higher confidence level that the firm's assets will be sufficient to cover liabilities over a 12 month period. This will effectively represent the worst loss a firm would be expected to incur in a single year over the next 200 years. Firms will, with prior consent from the FCA, be allowed to use an internal formula for the calculation, rather than the FCA standard. The SCR must be covered by at least 50 per cent Tier 1 capital. Less than 15 per cent of the SCR may be made up of Tier 3 capital.
Firms that fall below their SCR will trigger the "ladder of intervention", which consists of common European intervention tools aimed at recovering a firm's solvency position. While not as serious as a breach of the minimum standard, ultimately, if the solvency position continues to deteriorate, the FCA will have the power to take measures necessary to safeguard policy holders.
Pillar 2 - Systems of governance and risk management
Contrary to the general perception of the Directive, the capital requirements of Solvency II are arguably less of a potential concern for insurers than the systems of governance and risk management that are set out in Pillar 2.
Within this pillar are four "building blocks" of governance which reflect best practices that should already exist within firms. These building blocks are as follows:
- Own Risk and Solvency Assessment (ORSA) and capital management;
- A risk management system which will require modelling of potential risks as well as management of those risks;
- Policy processes and procedures that will need to be adapted and put in place; and
- Key functions, which cover the FCA’s controlled functions of:
- risk management;
- internal audit; and
There is broad scope for firms to outsource many of the systems and functions that will be required to comply with Solvency II.
Pillar 3 – Supervisory reporting and public disclosure
This aims to ensure consistent public disclosure and supervisory reporting across the EU. These requirements are designed to foster market discipline, and provide supervisors with the information needed for effective and proportionate supervision.
There are two limbs to the reporting regime:
- The Solvency and Financial Condition Report (SFCR) is an annual report made available publicly and provides detailed information on the firm’s solvency and financial condition; and
- The Regular Supervisory Report (RSR) is a private report between a firm and the national supervisor (FCA). This may contain information that is too secret or confidential to be published in the SFCR.
As Solvency II is a harmonising directive, there is limited scope for discretion in the transposition into UK law and the "intelligent copy-out" has resulted in the language of Solvency II being followed as closely as possible.
Despite its title, the most onerous requirements of Solvency II are related to the implementation of the required risk management structures which require significant amendments to those which firms already have in place. This is not to say that insurers are particularly happy at the prospect of setting aside huge sums of money in regulatory capital, and several of the biggest players in the industry had threatened to move their operating bases outside the EU if the requirements prove too burdensome.