Solvency II is the solvency regime for all EU insurers and reinsurers, which also covers the insurance operation of bancassurers. Due to come into effect on 1 January 2016, Solvency II aims to implement solvency requirements that better reflect the risks that companies face and deliver a supervisory system that is consistent across all member states. The challenge of preparing for and implementing Solvency II requires a multi-disciplinary approach.
As in Basel II for Banking, the regime has a three pillar structure, with each pillar governing a different aspect of the Solvency II requirements and approach: Quantitative requirements; Supervisor Review; and Market Discipline. As well as requiring firms to disclose their capital and risk frameworks, the Directive also asks firms to demonstrate how and where the requirements are embedded in their wider activities.
Embedding Solvency II
Forward planning for capital adequacy and risk management will become a part of any new strategic venture but the ‘embedding’ requirements as part of business as usual will also affect hedging and reinsurance strategies, product development and pricing, underwriting and investment management. Responding adequately to these new requirements will mean a major shift in thinking for many organisations – and a rigorous and planned approach to bridge the gap between standards now and those required for 2016.
Pillar 1: Quantitive requirements
Pillar 1 considers the quantitative requirements of the system, including the calculation of technical provisions, the rules relating to the calculation of the solvency capital requirements and investment management.
Pillar 1 sets out a valuation standard for liabilities to policyholders and the capital requirements firms will be required to meet.
There will be two Solvency requirements – the Minimum Capital Requirements (MCR) and the Solvency Capital Requirements (SCR). If the available capital lies between the SCR and the MCR, it is an early indicator to the supervisor and the insurance company that action needs to be taken.
An insurance company can choose whether to calculate the SCR using a standard formula set down by the regulator or whether to develop its own internal model to reflect the specific risks the organisation faces. If the later approach is adopted the insurer needs to gain approval from the supervisor.
Pillar 2: Supervisor review
Pillar 2 deals with the qualitative aspects of a company’s internal controls, risk, management process and the approach to supervisory review.
Pillar 2 includes the Own Risk and Solvency Assessment (ORSA) and the Supervisory Review Process (SRP).
Irrespective of whether a firm adopts the standard formula or internal model under Pillar 1 it has to produce an ORSA.
If supervisors are dissatisfied with a company’s assessment of the risk-based capital or the quality of the risk management arrangements under the SRP they will have the power to impose higher capital requirements.
Pillar 3: Reporting and disclosure
Pillar 3 is concerned with enhancing disclosure requirements in order to increase market transparency.
Companies must interpret the disclosure requirements, develop a strategy for disclosure and educate key stakeholders on the potential impact.
The onus is placed on firms to design the information which, through public disclosure, will be available to regulators, analysts, rating agencies and shareholders.
In addition, organisations must also develop the internal processes and systems to produce these reports.