Solvency regulation for insurance companies in the European Union is being fundamentally reformed. The Solvency II Directive will introduce a new solvency regime, based on an integrated risk approach, with provision for these risks in the form of solvency capital. Solvency II is an evolution from Solvency I, adopted in 2003. Implementation of Solvency II is currently planned for October 2012.

The objectives behind Solvency II are consumer protection for policy holders and assessing overall solvency of insurance companies using measures of solvency which better reflect the risks an insurer is exposed to. It will lead to greater harmonisation across financial sectors and harmonisation of supervisory methods across Europe. It is based on a similar approach to Basel II, which was introduced for the banking and securities industry in the EU from the beginning of 2008 through the Capital Requirements Directive.

Solvency II signals a fundamental shift towards a comprehensive enterprise risk management (ERM) culture. It requires risk management to be integrated into their day-to-day business decisions.

3 Pillar Approach

The development of Solvency II is based on a 3 Pillar Approach similar to the worldwide Basel II approach applicable to the banking and securities industry.

Pillar 1 - Quantitative requirements (Solvency)

• Financial data
• Internal models
• Expected losses

Pillar 2 - Qualitative requirements (Supervisory review)

• Risk management function
• Assess and maintain capital

Pillar 3 – Market discipline (Disclosure & transparency)

Timeframe for Solvency II

The development of Solvency II is following a Lamfalussy type consultative process, similar to the CRD and MiFID, namely:

• level 1 - Directive = framework, agreed by Council, Eurpoean Commission and European Parliament;
• level 2 - implementation, agreed by CEIOPS
• level 3 - detailed implementation by national regulators

The key milestones and dates are:

• 2008 - Quantitative Impact Study 4 (QIS4) undertaken and evaluated
• November 2008 - Draft Solvency II Directive published
• 2009 - Implementation arrangements made by national regulators and insurers
• June - November 2010 - Model dry-run for those accepted for the ‘internal models’ approach
• 2011 - Formal submissions for those accepted for ‘internal models’ approach
• October 2012 - Full implementation of Solvency II

Although final implementation is currently planned for 2012, firms which wish to be accepted for the models-based approach must undertake a dry run of their model in the second half of 2010, so there is much to do in a very short period. Planning for Solvency II should have started by now.

Solvency II in Summary

Solvency II is aimed at improving risk management across the insurance industry within the EU based on an integrated or enterprise risk management approach. Solvency II is principles, rather than rules based. Insurers will need to be able to explicitly identify risk interdependencies which will create incentives for insurers to develop their own internal risk models.

Solvency calculations will be based on market-consistent valuation of assets and liabilities. Risk based portfolio analysis is achieved by applying an integrated approach, taking into account dependencies between risk categories:

• Minimum Capital Requirement (MCR) - which is the level below which capital resources must not fall without posing an unacceptable risk to policy holders
• Solvency Capital Requirement (SCR) - sufficient capital to absorb significant unforeseen losses and assure policy holders that payments will be made as they become due. SCR can be established by using
  • Standard formula
  • Internal Models
  • Partial approach, i.e. a mix of internal model or standard formula according to the risk categories chosen by a firm

Own Risk and Solvency Assessment (ORSA)

An innovation for insurers is the necessity for all firms to undertake an ORSA, which will be reported to supervisors and made public. Through the ORSA, firms assess their risks, both short and long-term and the ‘own funds’ needed to cover them. It represents the entirety of the process and procedures employed to identify, assess, monitor, manage and report risks. It is a key part of how supervisors will assess the extent to which a firm has truly embedded risk management into its business decision-making process.

So what is different in Solvency II from Basel II?

Apart from the obvious differences in the industries to which these two regulatory regimes apply, Solvency II incorporates some of the development of regulatory thinking over the intervening period. For example, there is a much greater emphasis within Solvency II on the ORSA, than the earlier applications of ICAAP. Equally there is an increased emphasis on the need to have risk management embedded within day-to-day business decisions. This may mean that there is less scope for arbitrary regulatory “Pillar II add-ons”, but in return, insurers are going to have to manifest deep and sometimes radical changes in their own risk evaluation and culture.