What is Solvency II
Solvency II is the new European Directive for insurers (and reinsurers) to govern their capital requirements and to make significant improvements to policyholder protection. It is expected to come into force in January 2013 and it aims to gather all risk together in a holistic way.
Similar to Basel II it is based on a three pillar approach:
Pillar 1: Quantitative Requirements
The aim of Pillar 1 is to guarantee that all insurers are adequately capitalised. It uses a "total balance sheet approach" taking both assets and liabilities into account. All valuations for this pillar are to be based on market consistent valuations.
Pillar 1 outlines two capital requirements: (i) Minimum Capital Requirement (MCR) is the minimum level an insurer must hold at all times. If capital falls below this level, policyholders are open to an unacceptable level of risk and supervisors are expected to intervene and (ii) Solvency Capital Requirement (SCR) is the normal target level of capital required by a firm to cover the risks they are facing, this is calculated to ensure that an insurer can handle a 1 in 200 year event and still meet its policy liabilities. SCR can either be calculated by the standard model as outlined by the directive or by an internal model, subject to regulatory approval.
Pillar 2: Qualitative Review Process
Pillar 2 focuses on increasing risk management and governance within the firm. Insurers will be expected to produce an Own Risk and Solvency Assessment (ORSA). The ORSA will need to demonstrate that there are effective processes and strategies in place to assess risk and to calculate and maintain capital against these risks. It will need to reflect a forward looking approach to risk assessment. Supervisors have increased power under this second pillar and will be expected to challenge insurers if they are not comfortable with proposed risk management.
Pillar 3: Disclosure Requirements
Pillar 3 concentrates on transparency and demonstrating the reliability of the analysis of Pillars 1 and 2. Insurers are required to foster transparency by publishing key information in an understandable and consistent format for supervisors and the public.
What next?
Compliance with Solvency II offers firms a competitive and strategic advantage. Creating a direct link between risk management and capital motivates firms to improve their risk management in order to reduce required regulatory requirements.
It is recommended that insurers start working now to ensure that their organisations are fully compliant with the future directive. Solvency II is further reaching that its predecessor, Solvency I, and insurers need to be ready for the increased requirements.
FINCAD solutions have been helping insurance firms with their Solvency II compliance. To find out more information about FINCAD products and services, contact a FINCAD Representative.