CHAPTER 1: INTRODUCTION Insurance is a tool which has been introduced in order to protect the policyholders from any uncertain

loss. It is one of the most regulated industries which mainly deal on the account of risky nature of the business. In addition to this, it acts as a risk management technique through which the insured can be saved from the adverse events. It can easily hedge the insured against the risks & can cover the damage suffered by them. In order to maintain their promise, the European insurance companies have come up with the Solvency Regime in the early 1970s and this gave the EU one of the most competitive insurance markets in the world. This regime was from the insurers side to guarantee the insured that they are solvent enough to prot ect them from any unforeseen events. Solvency regime is the amount of regulatory capital an insurance undertaking is obliged to hold against unforeseen events. Under this regime, the insurance undertakings have to maintain an adequate solvency margin which is one of the most important common prudential rules. Solvency was the primary measure to be introduced in the EU insurance companies. This helped in measuring the ability of the insurer whether they are capable enough to remain solvent, though the method used for its calculation has

undergone substantial changes. Hence, solvency norms form the most important part of the supervisory compliance in insurance. TIMELINE FOR SOLVENCY: 1970: Solvency Regime 2002: Solvency I 2007: Solvency II Proposal 2014: Solvency II Effective Since the European insurers were not able to mitigate the risks because the design framed by the regulatory authority to identify the risk was simple and was not appropriate. So, this regulation was reviewed and they came up with Solvency I. Solvency I is basically the name given to the Europeans Insurer solvency regime which came into effect in 2002. WHY SOLVENCY I WAS INTRODUCED? Solvency I is the revised & updated form of the current EU solvency regime introduced in 2002. In addition to this, it has established more realistic minimum capital requirements, but still it does not reflect the true risk faced by the insurance companies. This regulation was being introduced in the EU insurance market in order to check the below mentioned points:

 To review the overall financial position of the insurance undertakings. To define the capital requirement by the undertakings. To protect the policyholders against the risks. After implementing Solvency I, there were developments in some areas like risk-management techniques, technical provisions, in the insurance companies.

DRAWBACKS OF SOLVENCY I Current Solvency I rules cannot cope up with the variety of the insurance company risks profiles as because the design which was used to identify the risks was simple & was not appropriate for the insurers to find out the quantity of risks involved in the portfolio. Solvency I has drawbacks in economic as well as in policy context. So, following are the some of them which are listed below: In the economic context: The insurers concentrated on policyholders protection but were less effective in meeting the other objectives.

 They mainly focused on the volume of the contracts rather than the risk inherent in the contract. The benefits of pooling & diversifying risk are recognized only to the limited extent. Group companies cannot benefit from the diversification that exists between the risks in their subsidiaries. They dont consider Asset Liability Management which occurred because of the mismatch between the assets & liabilities. It doesnt provide supervisors with tools that will provide high quality risk management & control. In the policy context: There were some weaknesses in the Prudential Regulation. This is the legal framework for the financial operation. It is basically to prevent or minimize the problem of the financial sector. The weaknesses of the regulation are as follows: It requires regular supervision. The best practices which were introduced were not supported by the banks.

 Diversification which can make the banks more secure and safe has not been explored from this regulation. Some more development was needed in the following areas: IFRS (International Financial Reporting Standards): As because previously only the listed companies were using this standard and rest of the companies were following local accounting principles. International development in the prudential regulation of insurance: Under this regulation, the rules or guidelines which were framed were not accepted by the undertakings and was not safe and secure. Regulatory development in the EU Member States: There needed more development in the guidelines, measures, and regulations in the European member states.

SOLVENCY II The Solvency II Directive 2009/138/EC is a current European Directive which has to be followed by the European (Re) Insurance Companies. Primarily, it is a fundamental & wide-ranging review of the European insurance directives wherein each (re)insurance undertakings has to update itself with the capital requirement in order to maintain its solvency. Solvency II Directive was proposed by the

European Parliament & European Council. Once the Omnibus II directive is approved by the European Parliament, Solvency II will be scheduled to come into effect on 1 January 2014. The European Union will be introducing this new regulation as this will help the insurance companies in measuring the financial stability. This approach will provide greater security to policyholders and will bring stability for financial markets as this will provide the insurance supervisors with better information. This acts as a tool in assessing the financial strength and the overall solvency of the insurance companies. It is a proposed EU legislation which will provide with a base to the prudential regulations for the measurement of the assets & liabilities. It is a risk-based system which helps in aligning the capital requirement keeping in view the risk factor of the (re)insurance undertakings. It is an opportunity to improve the insurance regulation. It is a fundamental review of the capital adequacy regime for the European insurance companies so that at the time of the losses by the policyholders, they can easily be available in order to support them. Basically, there main aim is to improve their risk-management standards in order to prevent them & replace the

Solvency I Directive as the techniques which were used to quantify the risk which were involved in the portfolio was not accurate. In order to prevent or minimize the risk associated with the financial sector, Solvency II also aims to review the prudential regulation which acts as drawbacks in the policy context of the Solvency I as this will help the insurance undertakings in maintaining the minimum capital adequacy. Solvency II also ensures that it seizes the opportunity to deliver a risk-based economic framework for the supervisory authorities & assures that it will enhance in protecting policyholders as well as the competiveness for the insurance sector & the wider European economy. It reflects the true risks involved as well as define the required capital & the techniques which can help in identifying the exact amount of risk involved in it. It is the positive tool to protect the policyholders. It also acts as a best method to mitigate the risk. Solvency II will bring the harmonization of asset and liabilities valuation techniques across EU as this will take into account asset liability management based on the market consistency. BACKGROUND

Solvency I was a minimum harmonization directive which was introduced in the European region. It primarily focused was on the prudential standards for insurers, and did not include requirements for risk management and governance within firms. Solvency II reflects new risk management practices to define required capital and manage risk. While 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: It establishes a base for the insurer in identifying the amount of risk involved. It acts as an incentive for the supervised institutions to measure and manage their risks. It enables the insurance companies to absorb significant unforeseen losses and gives reasonable assurance to policyholders. It brings assets and liabilities into fair value basis as it takes into account the assets and liabilities management. It harmonizes the standards across EU. It sets the capital requirements for the companies. It increases the competition among the insurance industry as it can better perform its key function of accepting risk.

TIMELINE FOR THE IMPLEMENTATION OF SOLVENCY II The timeline for the implementation of the Solvency II is to be decided by the European Insurance & Occupational Pensions Committee (EIOPC). EIOPA is the major work streams which draft the timelines, guidelines and standards to support the implementation of the new regime. EIOPA and its predecessor, CEIOPS, have been advising the European Commission in its various stages of development since 2004. It also helps the Omnibus II Directive in setting up the technical standards for the Solvency II. It gives constant support in taking final decisions by the European Parliament and European Council in framing the timelines. EIOPAs timeline for Solvency II:The Omnibus II Directive has set the date for the Solvency II regime as well as the scope of the technical standards which is being drafted by EIOPA. The implementation date of Solvency II is on 1 January 2014. As at May 2012, EIOPA expects to have the legal powers to consult on standards and guidelines from late autumn 2012. This timeline should allow EIOPA, its members and the firms to prepare for the implementation of Solvency II. In the meantime, EIOPA is also consulting with the Insurance and Reinsurance Stakeholder Group as part of EIOPAs preparation of draft guidelines and technical standards. In addition,

EIOPA aims to support supervisors and undertakings in specific areas. For example, it supporting in preparing for the efficient and timely approval of internal models which will help for the calculation of the solvency requirements. The models will be approved only it has passed the pre-application phase and the possibility to introduce this phase for an internal model is 2012 and the flexibility for receiving applications from 1 January 2013 onwards. The following below is the pictorial presentation for the implementation of the process: From Regulation

To Supervision

[SOURCE: EIOPA UPDATE ON TIMELINE IMPLEMENTATION OF SOLVENCY II] The standards and guidelines are expected to cover the following areas: Internal models, Solvency capital requirements, Own funds, Technical provisions, Valuation of assets and liabilities Group supervision Supervisory transparency and accountability, Reporting and disclosure Governance, ORSA Supervisory review process, Capital add-ons. COVERAGES: EU (re) insurer with annual premiums more than EUR 5 Million. Coverage is neutral in respect of the legal form of the (re) insurer. The coverage will be given to the European Based Captives.

 Reinsurers in run-off operations will be treated neutrally only if they are well managed run-off. No credit will be given to them. EU branches and subsidiaries of non-EU based groups. 3 PILLARS OF SOLVENCY II As like in banking we have BASEL II for the insurers for the banking regulation, likewise we have 3 Pillars in Solvency II for the insurers to protect the policyholders. The guidelines for the three pillars will be given by Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS). The proposed Solvency II framework has three main pillars: PILLAR 1 consists of the quantitative requirements, i.e. the amount of capital an insurer should hold. PILLAR 2 sets out requirements for the supervisory review. PILLAR 3 focuses on disclosure and transparency requirements.

The explanation on the three pillars has been discussed below: PILLAR 1: Quantitative Requirements Pillar 1 covers the quantitative requirements of Solvency II. This pillar contains: Calculation of Technical Provisions (i.e., Reserves). Calculation of Solvency Capital Requirement. Minimum Capital Requirement. Technical Provisions has to be maintained by each undertaking which will help the companies in mitigating the risk as well as in protecting the policyholders. Technical provisions comprise two components: the best estimate of the liabilities

plus a risk margin. It is the amount the (re) insurance companies have to pay in order to immediate transfer its obligations. Within this pillar there are two capital requirements the Solvency Capital Requirement (SCR) and the Minimum Capital Requirement (MCR) which represent the different levels of supervisory intervention. Solvency Capital Requirement is a normal target level of capital for a firm. The exact amount can be derived either through a firms own capital model or through a standard or generic capital model. The SCR is a risk-based requirement and acts as the key solvency control level. The SCR will cover all the quantifiable risks an insurer or reinsurer faces. Risk mitigation techniques are also a salient factor in relation to SCR calculations. The required solvency capital has to guarantee a capital level that allows an insurance firm to absorb unforeseen large losses and gives policyholders a reasonable assurance that payments will be made in due time and form. There are two methods for the calculation of the SCR which have been developed by the (re)insurance companies. The European Standard Formula or Firms' or insurers own internal models.