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 31 Dec 2012. [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 supervisors early warning 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.
Solvency I vs. Solvency II
Since the introduction of the first Solvency framework in the early 1970s, sophisticated risk management systems have been developed. Solvency II introduces a comprehensive framework for risk management for defining required capital levels and to implement procedures to identify, measure, and manage risk levels.
The EC has published some FAQs on Solvency II
The pillar 1 framework set out qualitative and quantitative requirements for calculation of technical provisions and Solvency Capital Requirement(SCR) using either a standard formula given by the regulators or an internal model developed by the (re)insurance company. Technical provisions represent the current amount an (re)insurance company would have to pay for an immediate transfer of its obligations to a third party. The SCR is the capital required to ensure that the (re)insurance company will be able to meet its obligations over the next 12 months with a probability of at least 99.5%. In addition to the SCR capital a Minimum Capital Requirement (MCR) must be calculated which represents the minimum level of capital the breach of which results in supervisory action.