Solvency II is an EU legislation that sets out the capital requirement rules for direct life and non-life insurance and reinsurance companies which are already established or wish to be established within the European Union. Companies that fall within the scope of the Solvency II Directive and which meet its requirements will benefit from a single license to operate within all EU member states. Enforcement and implementation of the Directive is set for October 2012.
The Solvency II capital requirement approach is based on a total balance sheet, economic risk based approach that comprises of the following features:
1. Assets and liabilities will be valued on a market-consistent basis.
a. For assets this means they will be valued at an amount that knowledgeable willing parties in an arm’s length transaction would pay for them.
b. For insurance liabilities this means technical provisions cover the best estimate plus risk margin where:
- The best estimate is the probability weighted average of future cash flows discounted for time using the relevant risk-free term structure of interest rates. It will be based on realistic assumptions, information available in financial markets and that generally available on underwriting risks.
- The risk margin is assessed so that the value of the liabilities is representative of transfer or settlement value of liabilities in an arm’s length transaction by willing knowledgeable parties.
- Both these components will be calculated separately except in the case when the future cash flows can be replicated by a financial instrument whose market value is observable. In such cases the value of the technical provisions on the whole (best estimate + risk margin) would be determined on the basis of the market value of these instruments.
2. Companies will have to meet a risk-sensitive Solvency Capital Requirement (SCR) which is the level of capital needed to absorb unforeseen losses and provide assurance to policyholders and benefits that obligations will be met when due (specifically a 99.5% probability that obligations will be met over the next 12 months based on a Value-at-Risk approach), calculated on a prospective going concern basis. A breach of this requirement would mean that the company would have to cover the deficit in eligible own funds over a certain period of time and according to a workable plan approved by its supervising authority. SCR needs to be calculated at least annually, monitored on a continuous basis and recalculated if the company’s risk profile changes.
a. Own funds refer to basic own funds and supervisor approved amounts of ancillary own funds. Own funds are classified into three tiers based on whether they are basic or ancillary items and depending on their loss absorption quality in a ‘going-concern’ or ‘winding-up’ basis.
b. Tier 2 and Tier 3 own funds are subject to quantitative limits for the assessment of SCR.
3. Companies will also have to meet a Minimum Capital Requirement (MCR). This is a lower (read stricter) level of requirement of eligible own funds needed that if breached could result in the revocation of the company’s authorization to pursue business, establish itself and provide services under the Solvency II Directive which is the highest level of supervisory intervention. The objective of both capital requirements is policyholder and beneficiary protection.
a. Tier 2 basic own funds are subject to quantitative limits for the assessment of MCR.
4. In the determination of its capital requirements the company will account for any risk mitigation and diversification techniques that it employs.
5. There is a choice between two calculation methodologies for determining SCR. One is the European Standard Formula method and the other is the company’s own internal models. Companies may use either 1) the standard formula or 2)a full internal model or 3)they may use partial internal modules for certain sub-modules or business units together with the standard formula for the rest of the modules or business units.
a. For the standard formula a modular approach is used where the risk for each category (market risk, credit risk, underwriting risk (life, health, non-life), operational risk, etc) is calculated separately first and then aggregated across all risk categories accounts for any correlations between risks as well as correlation between sub-module risks.
- The capital requirement for underwriting risk covers the adverse changes to the liabilities due to changes in the underlying reserving, pricing and provisioning assumptions
- The capital requirement for market risk covers the adverse changes to the values of assets and liabilities due to the movements in the level and volatility of market prices/ interest rates/ spreads, the structural mismatch between assets and liabilities, and concentration and issuer counterparty risks.
- The capital requirement for counterparty risk covers the risk of unexpected default or deterioration of credit quality of the counterparties
b. The internal models, both full and partial, have to meet specific criteria, including a use test, and are approved by the supervising authority before they may be used.
6. The determination of MCR is based on a simple formula subject to an absolute floor and a floor and cap based on the risk sensitive SCR measure. It is calibrated to a Value at Risk measure corresponding to an 85% probability that the next 12 month obligations will be met. The MCR will be calculated at least on a quarterly basis.
Like Basel II for banks, Solvency II for EU’s insurance and reinsurance companies comprises of 3 Pillars:
- Pillar I details the quantitative requirements which involve the valuation of assets, liabilities and capital requirements.
- Pillar II pertains to the qualitative requirements that seek to assess the company’s internal risk management and controls, in particular an Own Risk and Solvency Assessment process that accounts for a company’s specific risk profile, and supervisory review and intervention if necessary.
- Pillar 3 addresses the reporting and disclosure requirements of the entity. It comprises of public disclosure (to enhance transparency, market discipline and stability of the insurance/ reinsurance industry) and greater supervisory reporting. The disclosure requirements are to meant be frequent, forward-looking and relevant.