Solvency II is a new framework developed by the European Commission which will update the existing outdated Solvency I regime.
The European Parliament approved the Solvency II framework directive on 22 April 2009 and it is now scheduled to come into force on 31 October 2012. Solvency II will result in one of the largest changes ever experienced by insurance industries across Europe and will change capital requirements for insurance companies. The change could be compared with the way Basel II changed capital requirements for banks.
This article describes the far reaching implications of the Solvency II program implementation for both the investor community and policy holders.
Current regime.
The current solvency regime is outdated since it was created in the 70's with some small changes as from January 2004 (Solvency I). According to the Solvency I directive the required solvency margin is set to: Life: 4% of the reserve and 0.3% of risk capital. Non-life: percentage of premiums, namely 18% of the first 10 million and 16% of the remainder.
This situation does not reflect risk properly and in some cases current rules can actually conflict with best practices in risk management. For example a company that increases its non-life premiums with no changes in liabilities reduces its risk of insolvency, but its capital requirements would increase.
Why Solvency II?
The main objective of (re)insurance regulation and supervision is adequate policyholder protection. Other objectives such as financial stability and fair and stable markets should also be taken into account but should not undermine that main objective.
The change in the required capital ratio for individual companies will depend on their own risk profile. Companies with lower risk will have significantly lower solvency requirements.
In particular, capital requirements will reflect the specific risk-profile of each (re)insurance undertaking. Insurers that manage their risks well - because they have rigorous policies, use appropriate risk-mitigation techniques, or diversify their activities - will be rewarded and allowed to hold less capital than under the current EU regime. On the other hand, poorly managed insurers, or insurers with a larger risk appetite, will be asked to hold more capital in order to ensure that policyholder claims will be met when they fall due.[1]
The Three Pillars of Solvency II
Solvency II adapted the same pillar structure as Basel II.
Pillar I determines future "target capital" and "safeguard capital" requirements and provides quantitative requirements.
Pillar II defines more qualitative requirements, the internal risk controls, and the role of supervisors.
Pillar III installs sound risk management by disclosure, and transparency requirements introducing control by the market and consumers.
Key market drivers:
The following market drivers have been identified during market research conducted by Capgemini: consolidation/ M&A, new products, distribution, cost control and, profitability, regulatory and investor pressures on risk provisions, capital markets volatility, outsourcing non-core business.[2]
The current business environment requires quicker ROI, speed to market and transparency.
The future conditions will create a consistent view on solvency measures across all parties. The main measurements are:
MCR - Minimum Capital Requirement:
A level of capital below which ultimate supervisory action would be triggered
SCR - Solvency Capital Requirement
- Standard Formula
- Internal Models
A level of capital that enables an institution to absorb significant unforeseen losses. It also provides a reasonable assurance to policyholders.
Capital adequacy: pillar 2 and 3 assessment.
The starting point for the adequacy of the quantitative requirements in the (re)insurance sector is the solvency capital requirement. Therefore supervisory authorities may require more capital only under strictly defined exceptional circumstances following the Supervisory Review Process.
Lessons from Basel II:
The main lesson learned from the experience in the Basel II program implementation is that the whole project is not just a risk modeling exercise; business should take a driving seat. The Program Structure and Governance is one of the key areas to address, along with other crucial areas - definition of Technology Strategy, Data management, Pillar 2 and ERM implementation.
Differences between Solvency II and Basel II:
The main difference is the requirement that Solvency II models and risk management systems be truly integrated into the firm's business decision process. That will be assessed during supervisory visits and interviews and through documentation - i.e. do the Board and relevant committee papers and minutes clearly indicate that capital and risk considerations have been fully communicated and incorporated into decisions.
Consequences for supervisors and rating agencies.
Supervisors have the power to enforce additional capital requirements.
Supervision shall be based on a prospective and risk-oriented approach. Solvency II therefore adopts an economic risk-based approach which allows for a system that reflects the true risk profile of (re)insurance undertaking... particular care has been taken to ensure that the new solvency regime is not too burdensome for small and medium-sized (re)insurance undertakings.[3]
Rating agencies are also actively involved, by focusing on the ability of insurance companies to quantify and manage risk. The rating analysis contains nine elements. Two of these - management and corporate strategy, and enterprise risk management (ERM) - have similarities with Solvency II Pillar 2. Four further elements; capitalisation, investments, liquidity and reserves, are more aligned with Pillar I.[4]
The view of industry associations.
One of the top priorities identified by both the CEA (European assurances commission) and CRO forums is valuation of insurance liabilities.In this area two main methods have been identified; Market value liabilities (MVL) -Definition: 'The value at which the liabilities could be transferred to a willing, rational, diversified counterparty in an arms' length transaction under normal business conditions (= no fire sale or 'large volume' discounts)'.
The MVL can be decomposed into two component parts:
1. The value of the Financial Components (FC)-incorporating 'best estimate' actuarial assumptions
2. The value of Non-Financial Components (NFC), that covers the uncertainty of those non-financial actuarial risks.
Each component should be valued using an appropriate cost of capital for all risk, not through the use of a common Weighted Average Cost of Capital (WACC).
The value of hedgeable risks should be determined by mark-to-market approaches, i.e. where market prices can be observed they should be used; this is conceptually identical to a best estimate plus market value margin (MVM) approach, except that in this case the observed market price already includes the MVM
o The value of non-hedgeable risks is determined by an appropriate mark-to-model approach:
For non-hedgeable insurance risks, liability values are determined as best estimate plus MVM based on a 'cost of capital' approach
Next steps:
Recently some insurers participated in Quantitative Impact Studies (QIS), the last one being QIS4. These studies are used to test the design and calibration of the future European Standard formula. Participation is voluntary and allows firms to obtain an early indication of work needed and influence the Solvency regime.
A key objective of QIS4 was to study the effect on the own-funds of insurance
undertakings and groups. The overall quality of response was high and most firms completed at least the main data input items in the spreadsheet.
The next year will present the next big milestone for insurers. Firms must be able to demonstrate that they satisfy the dry run entry criteria and have made significant progress towards meeting internal model requirements. Firms must also be in a position to articulate the results of their gap analysis and plans to action.
Conclusion:
The EU Commission President Jose Manual Barroso said recently:
"Solvency II will help protect policy holders from bad practice. It will help shield our economies against a repeat of the disastrous excessive risk taking by financial institutions, including certain insurance operators, that has contributed to the global crisis."
The main benefits for stakeholders such as investors, customers/policyholders, supervisors are the following:
* Establishment of a more competitive single market
* Better product pricing
* Increased efficiency in the use of capital and improvement of profitability
* Shifting from volume based solvency requirements to risk based rules which will benefit all stakeholders.
* Closer alignment between the insurance companies, regulators and rating agencies can only be beneficial to all stakeholders.
Insurers applying best practice will be further rewarded by investors, market participants and consumers.[5]
The firms which will take early actions can gain an advantage against competition and increase their shareholders value.
References:
1. CEIOP. Solvency II directive.
Do you want to learn more about Risk management? Does your organisation require help in setting up and benchmarking of the Continuity Management framework?
The European Parliament approved the Solvency II framework directive on 22 April 2009 and it is now scheduled to come into force on 31 October 2012. Solvency II will result in one of the largest changes ever experienced by insurance industries across Europe and will change capital requirements for insurance companies. The change could be compared with the way Basel II changed capital requirements for banks.
This article describes the far reaching implications of the Solvency II program implementation for both the investor community and policy holders.
Current regime.
The current solvency regime is outdated since it was created in the 70's with some small changes as from January 2004 (Solvency I). According to the Solvency I directive the required solvency margin is set to: Life: 4% of the reserve and 0.3% of risk capital. Non-life: percentage of premiums, namely 18% of the first 10 million and 16% of the remainder.
This situation does not reflect risk properly and in some cases current rules can actually conflict with best practices in risk management. For example a company that increases its non-life premiums with no changes in liabilities reduces its risk of insolvency, but its capital requirements would increase.
Why Solvency II?
The main objective of (re)insurance regulation and supervision is adequate policyholder protection. Other objectives such as financial stability and fair and stable markets should also be taken into account but should not undermine that main objective.
The change in the required capital ratio for individual companies will depend on their own risk profile. Companies with lower risk will have significantly lower solvency requirements.
In particular, capital requirements will reflect the specific risk-profile of each (re)insurance undertaking. Insurers that manage their risks well - because they have rigorous policies, use appropriate risk-mitigation techniques, or diversify their activities - will be rewarded and allowed to hold less capital than under the current EU regime. On the other hand, poorly managed insurers, or insurers with a larger risk appetite, will be asked to hold more capital in order to ensure that policyholder claims will be met when they fall due.[1]
The Three Pillars of Solvency II
Solvency II adapted the same pillar structure as Basel II.
Pillar I determines future "target capital" and "safeguard capital" requirements and provides quantitative requirements.
Pillar II defines more qualitative requirements, the internal risk controls, and the role of supervisors.
Pillar III installs sound risk management by disclosure, and transparency requirements introducing control by the market and consumers.
Key market drivers:
The following market drivers have been identified during market research conducted by Capgemini: consolidation/ M&A, new products, distribution, cost control and, profitability, regulatory and investor pressures on risk provisions, capital markets volatility, outsourcing non-core business.[2]
The current business environment requires quicker ROI, speed to market and transparency.
The future conditions will create a consistent view on solvency measures across all parties. The main measurements are:
MCR - Minimum Capital Requirement:
A level of capital below which ultimate supervisory action would be triggered
SCR - Solvency Capital Requirement
- Standard Formula
- Internal Models
A level of capital that enables an institution to absorb significant unforeseen losses. It also provides a reasonable assurance to policyholders.
Capital adequacy: pillar 2 and 3 assessment.
The starting point for the adequacy of the quantitative requirements in the (re)insurance sector is the solvency capital requirement. Therefore supervisory authorities may require more capital only under strictly defined exceptional circumstances following the Supervisory Review Process.
Lessons from Basel II:
The main lesson learned from the experience in the Basel II program implementation is that the whole project is not just a risk modeling exercise; business should take a driving seat. The Program Structure and Governance is one of the key areas to address, along with other crucial areas - definition of Technology Strategy, Data management, Pillar 2 and ERM implementation.
Differences between Solvency II and Basel II:
The main difference is the requirement that Solvency II models and risk management systems be truly integrated into the firm's business decision process. That will be assessed during supervisory visits and interviews and through documentation - i.e. do the Board and relevant committee papers and minutes clearly indicate that capital and risk considerations have been fully communicated and incorporated into decisions.
Consequences for supervisors and rating agencies.
Supervisors have the power to enforce additional capital requirements.
Supervision shall be based on a prospective and risk-oriented approach. Solvency II therefore adopts an economic risk-based approach which allows for a system that reflects the true risk profile of (re)insurance undertaking... particular care has been taken to ensure that the new solvency regime is not too burdensome for small and medium-sized (re)insurance undertakings.[3]
Rating agencies are also actively involved, by focusing on the ability of insurance companies to quantify and manage risk. The rating analysis contains nine elements. Two of these - management and corporate strategy, and enterprise risk management (ERM) - have similarities with Solvency II Pillar 2. Four further elements; capitalisation, investments, liquidity and reserves, are more aligned with Pillar I.[4]
The view of industry associations.
One of the top priorities identified by both the CEA (European assurances commission) and CRO forums is valuation of insurance liabilities.In this area two main methods have been identified; Market value liabilities (MVL) -Definition: 'The value at which the liabilities could be transferred to a willing, rational, diversified counterparty in an arms' length transaction under normal business conditions (= no fire sale or 'large volume' discounts)'.
The MVL can be decomposed into two component parts:
1. The value of the Financial Components (FC)-incorporating 'best estimate' actuarial assumptions
2. The value of Non-Financial Components (NFC), that covers the uncertainty of those non-financial actuarial risks.
Each component should be valued using an appropriate cost of capital for all risk, not through the use of a common Weighted Average Cost of Capital (WACC).
The value of hedgeable risks should be determined by mark-to-market approaches, i.e. where market prices can be observed they should be used; this is conceptually identical to a best estimate plus market value margin (MVM) approach, except that in this case the observed market price already includes the MVM
o The value of non-hedgeable risks is determined by an appropriate mark-to-model approach:
For non-hedgeable insurance risks, liability values are determined as best estimate plus MVM based on a 'cost of capital' approach
Next steps:
Recently some insurers participated in Quantitative Impact Studies (QIS), the last one being QIS4. These studies are used to test the design and calibration of the future European Standard formula. Participation is voluntary and allows firms to obtain an early indication of work needed and influence the Solvency regime.
A key objective of QIS4 was to study the effect on the own-funds of insurance
undertakings and groups. The overall quality of response was high and most firms completed at least the main data input items in the spreadsheet.
The next year will present the next big milestone for insurers. Firms must be able to demonstrate that they satisfy the dry run entry criteria and have made significant progress towards meeting internal model requirements. Firms must also be in a position to articulate the results of their gap analysis and plans to action.
Conclusion:
The EU Commission President Jose Manual Barroso said recently:
"Solvency II will help protect policy holders from bad practice. It will help shield our economies against a repeat of the disastrous excessive risk taking by financial institutions, including certain insurance operators, that has contributed to the global crisis."
The main benefits for stakeholders such as investors, customers/policyholders, supervisors are the following:
* Establishment of a more competitive single market
* Better product pricing
* Increased efficiency in the use of capital and improvement of profitability
* Shifting from volume based solvency requirements to risk based rules which will benefit all stakeholders.
* Closer alignment between the insurance companies, regulators and rating agencies can only be beneficial to all stakeholders.
Insurers applying best practice will be further rewarded by investors, market participants and consumers.[5]
The firms which will take early actions can gain an advantage against competition and increase their shareholders value.
References:
1. CEIOP. Solvency II directive.
Do you want to learn more about Risk management? Does your organisation require help in setting up and benchmarking of the Continuity Management framework?
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