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Solvency II
A closer look at the evolving
process transforming the
global insurance industry
kpmg.com
2 Solvency II
Executive summary (1)
Why should the U. S. Insurance Industry care about Solvency II (2)
What is Solvency II? (3)
Table of Contents
Exploring the three pillars (6)
Compairing U.S. and EU systems (8)
The devil is in the detail (9)
The information contained herein is of a general nature and is not intended to
address the
circumstances of any particular individual or entity. Although we endeavor to
provide accurate and
timely information, there can be no guarantee that such information is accurate as
of the date it is
received or that it will continue to be accurate in the future. No one should act
on such information
without appropriate professional advice after a thorough examination of the
particular situation.
© 2011 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm
of the
KPMG network of independent member firms affiliated with KPMG International
Cooperative
(“KPMG International”), a Swiss entity. All rights reserved. Printed in the U.S.A.
The KPMG
name, logo and “cutting through complexity” are registered trademarks or trademarks
of
KPMG International. 24110NSS
Solvency II 3
Uncovering the benefits
of strategic implementation (15)
Realizing the impact on
the United States and the world (17)
U. S. reform: The Solvency Modernization Initiative (18)
Achieving equivalence (20)
Understanding an
evolving process (21)
EIOPA Prepares for the Future (22)
Summary (25)
Glossary (26)
1 Solvency II
Executive summary
The Solvency II Directive is a world-leading standard that requires insurers to
focus on managing all of
the risks facing their organization. It offers European insurers a real opportunity
to improve their riskadjusted
performance and operational efficiency, which is likely to be good news for
policyholders, for
the insurance industry, and the European Union (EU) economy as a whole.
Solvency II is not only on the radar of insurance companies in the EU, but also on
those across the
globe. The world is watching to see how the EU transforms its insurance industry
and implements
risk-based improvements to protect policyholders. At the same time, shareholders
are also likely
to reap benefits. And while it may seem far enough away, much still needs to be
accomplished to
accommodate the vast changes and potential impact to insurance companies,
governments, and
rating agencies within the EU and beyond.
Solvency II is very much a living process and continues to evolve through valuable
consultation,
feedback, and cooperation between the insurance industry and regulatory bodies. As
the process
unfolds, unforeseen challenges and opportunities encourage progress and enable
adjustments
toward achieving the EU’s goals for the insurance industry. The framework will
follow the Basel
Accord approach, with a three-pillar structure, which will bring insurance and
reinsurance regulation
more in line with regulation applied to the banking community. Therefore, it is not
surprising that the
insurance industry is diligently preparing for Solvency II and learning along the
way by following a more
comprehensive, communicative, and structured path towards implementation.
So, since this is a European initiative, why should the U.S. insurance industry
concern itself with
Solvency II? U.S. companies will feel both direct and indirect impacts resulting
from Solvency II (see
sidebar on next page) and a lack of awareness could result in competitive
disadvantages in the future.
This paper provides an overview of the Solvency II regime, its likely impact on the
insurance market,
and the potential implications on the U.S. and global insurance industry. In
particular, this paper aims to:
• Identify the goals and objectives of the Solvency II Directive
• Provide an outline of the key building blocks
• Recognize the strategic benefits and implications that Solvency II will have
for the global
insurance industry as well as the direct impact to the U.S. insurance industry
• Understand the complex processes involved and the progress being made to
date.
Solvency II
Although Solvency II is an EU regulatory initiative,
it will have both direct and indirect implications to
the U.S. insurance industry. In the absence of an
equivalent regime, group supervision holds the
greatest direct impact for the United States, group
supervision, and related third-country undertakings
(these requirements are discussed further later
in this paper). U.S. companies are likely to also
face indirect demands from a change in market
competition, rating agencies, and regulators.
U.S. subsidiaries of an EU parent: U.S. companies
that are subsidiaries of a European parent will need
to be consolidated with their European counterparts
and the Solvency II groups requirements applied to
the consolidated position of the overall European
parent. “Major” (i.e., significant to the group) nonEuropean
subsidiaries will likely need to incorporate
significant aspects of the Solvency II requirements
locally. This is likely to have significant risk and capital
management, data, and system implications.
EU subsidiaries of a U.S. parent: Under Solvency
II, upward group supervision is triggered by the
existence of an EU insurance company being
owned by a non-EU parent company or group
of companies. The intent of Solvency II’s group
supervision requirements is to protect the
policyholders of European insurers from the risks
associated with the wider group of which they are
part, either due to the level of group connectivity
or due to insufficient coverage of the group’s
insurance risks with readily transferable capital.
Competitive environment: U.S. companies that
implement Solvency II with an eye to integrating
risk, finance, and strategy will be in a stronger
position to react to economic changes with
mitigation strategies. As a result, the increased
adoption of Solvency II by international insurance
companies could make the competitors smarter,
and U.S. companies will have to consider adopting
sophisticated risk and performance management
in order to keep pace.
Achieving growth in the U.S. market is certainly
at the top of the corporate agenda for many
companies. Today, growth is difficult to achieve in
the more mature insurance markets and products.
Solvency II methods may actually start to move into
pricing and product innovation through changes in
capital allocations which could ultimately change
the competitive landscape. There is certainly
speculation that such new views of optimal capital
positions could result in increased M&A activity in
the marketplace.
Rating agencies: Solvency II is driving some
companies to build more robust capital models and
imposes higher standards of corporate governance
and risk management. Rating agencies are
considering using these improved capital models
to compare and assess companies across markets
and are putting more value on better-structured
corporate governance models and improved risk
management. Some rating agencies are already
moving towards using Solvency II to serve as a
guide, as it imposes higher standards of corporate
governance, risk management, and its integration
with economic capital modeling. To the extent
that Solvency II, in whole or in part, can be viewed
as providing perspectives on “best practices,”
companies should at a minimum gain familiarity
with its provisions and the potential implications.
Regulatory change: The National Association
of Insurance Commissioners’ (NAIC) program
of Solvency Modernization, which began in
mid-2008, has been challenged to improve
the U.S. solvency framework. In doing so,
it is looking at the new IAIS 2011 principles
to which the NAIC signed up. There are significant
linkages between IAIS principles and Solvency
II, with NAIC specifically considering enhanced
governance, Own Risk Solvency Assessment,
Supervisory Colleges, sharing of information with
other regulators, and recalibration of the Risk
Based Capital (RBC) standards.
Why should the U.S. insurance industry care
about Solvency II?
2
3 Solvency II
What is Solvency II?
The Solvency II Directive is a new regulatory framework for the European insurance
industry that adopts a more dynamic risk-based approach and implements a
non-zero failure regime, i.e., there is a 0.5 percent probability of failure. One
of
the main aims of Solvency II is to contribute to the objectives of the EU Financial
Services Action Plan (FSAP) by encouraging a deeper single insurance services
market that enables EU companies to operate with a single license throughout
member countries. It will do this by introducing a unified legal framework for
prudential regulation for all insurance and reinsurance entities operating in the
EU;
the Directive will help maximize harmonization and will be consistent with the
principles used in banking supervision. This new single market approach is based
on economic principles that measure assets and liabilities to appropriately align
insurers’ risks with the capital they hold to safeguard policyholder.
Similar to the reasoning behind Basel II, the new framework is being implemented,
in part, as a result of the previous market turmoil, which highlighted system
weaknesses and renewed awareness over the need to modernize industry
standards and improve risk management techniques. As a result, Solvency II
sets out to establish its new set of capital requirements, valuation techniques,
and governance and reporting standards to replace the existing and outdated
Solvency I requirements. In particular, the new regime is intended to harmonize the
regulations across the EU, replacing the piecemeal system under which different
countries have implemented the Solvency I rules in different ways, particularly for
group supervision, to a single unified regime.
In addition, changes to capital requirements will provide a better reflection of an
insurer’s individual risk profile and should encourage major insurers to develop
their
own internal models for setting the Solvency Capital Requirement (SCR), while
many smaller companies are more likely to opt for the standard formula to calculate
the SCR. This is likely to lead to a supervisory need for companies to show greater
competency in risk assessments. The new system will also require a more unified
approach for evaluating technical provisions.
Solvency II 4
Solvency II time line
On April 22, 2009, the European Parliament approved the Solvency
II framework directive, due to become effective January 1, 2013. The
European Council announced this month, June 21, 2011, a proposal to
delay implementation of Solvency II to January 1, 2014, subject to European
Parliament approval. The European and local regulators’ positions remain
unclear, and it should be noted that there is no material change to the underlying
principles to implementation requirements. We suspect firms will continue to
push forward with implementation.
In summary, the regime intends to provide:
• Alignment of economic and regulatory capital including giving appropriate
recognition to diversification benefits within companies and between subsidiaries
• Freedom for companies to choose their own risk profile and match it with an
appropriate level of capital
• An early warning system for deterioration in solvency by active capital
management
• By better aligning risk and capital management, encouraging an improvement
in the identification of risks and their mitigation.
According to the EU Commission,1
the Directive will “also streamline the way
that insurance groups are supervised and recognize the economic reality of
how groups operate. The new regime will strengthen the powers of the group
supervisor, ensuring that groupwide risks are not overlooked, and demand greater
cooperation between supervisors. Groups will be able to use groupwide models
and take advantage of group diversification benefits.”
1 http://ec.europa.eu/index_en.htm
5 Solvency II
Solvency I
Regulatory Requirements
RMM
Standard
SCR
Adjusted
SCR MGF 2 2
1 1a
1b
Regulatory Requirements Management Model
Surplus
Capital
Technical
Provisions
Surplus
Capital Surplus
Capital
Capital Add-on
SCR
MCR
IECR
Margin
Margin
Best Estimate
of Liabilities
Best Estimate
of Liabilities
Solvency II Solvency II
1) Technical provisions to
match insurers' liabilities
a) Best estimate of
liabilities
b) Market Value Margin
2) Regulatory capital
requirements
3) Capital held in excess of
regulatory capital
requirements
3 3
Minimum Capital Requirement (MCR) – the minimum level of regulatory capital
Solvency Capital Requirement (SCR) – the risk-based level of regulatory capital
Adjusted SCR – SCR level which includes any supplementary capital requirement
determined through the Pillar 2 Supervisory review
IECR – management’s internal estimate of capital need
Figure 1: Changing regulatory requirements
The first two columns compare the basic framework designs of the Solvency I
and Solvency II regimes in terms of the regulatory requirements. The third column
depicts the economic capital model that a firm might use to run the business, which
is known as the Internal Economic Capital Requirement (IECR). While surplus capital
under Solvency I and Solvency II appears to be similar, the actual situation will
vary
from company to company, with some seeing more surplus capital under the new
regime and some less.
Solvency II 6
The European Insurance and Occupational Pensions Authority (EIOPA) defines
the three pillars as a way of grouping Solvency II requirements (the concept of
pillars is not described in the Directive), which aim to promote capital adequacy,
provide greater transparency in the decision-making process, and enhance the
supervisory review process—all in the name of good risk management and
policyholder protection. This is to be achieved through the implementation of
a holistic approach that addresses better risk measurement and management,
improves processes and controls, and institutes an enterprise-wide governance
and control structure. While Solvency II is split into three pillars, Pillars 2 and
3 are
often referred together as Pillar 5 due to the synergies between them.
Figure 2: Solvency II framework
Insurance risk
Market risk
Liquidity risk
Credit risk
Operational risk
Governance
Legal/Organizational Structure
Risk strategy and
appetite
Outsourcing Reinsurance
Systems and data
Policies, standards and definitions
Internal Control
Monitoring and
mangement Reporting and MI
Capital Requirements
(SCR/MCR)
Models and
Validation
Quantitative
Measures
Use Test Disclosure
Pillar I Pillar II Pillar III
Own Risk and
Solvency
Assessment
(ORSA)
A breakdown of the Solvency II Three Pilars framework into its constituent
components, so as to identify Solvency II Target Operating
Model. Each aspect of the Solvency II framework interacts end links to other areas.
No components should be looked at in isolation.
Exploring the three pillars
7 Solvency II
As widely noted, Solvency II is similar in structure to the Basel II regulation for
the banking industry. Both are based on three pillars that include quantitative and
qualitative requirements and market discipline, and include specific components
that focus on capital, risk, supervision, and disclosure. However, it is important
to acknowledge that banking and insurance are distinctly different industries.
Therefore, the implementation process for Solvency II cannot just mirror that of
Basel II. Each represents a unique process unto itself as they deal with very
different
business models and different types of risk. While similarities surely exist, there
are
considerable differences in the requirements, application, and impact of each
pillar.
This is particularly true in Pillar I, with Basel II applying separate models for
investment, credit, and operational risks while Solvency II focuses on a riskbased
portfolio analysis by applying an integrated approach, taking into account
dependencies between risk categories. Furthermore, Basel II concentrates on the
asset side, while Solvency II’s assessment of capital adequacy applies economic
principles on the total balance sheet, i.e., both the assets and liabilities.
Pillar 1 covers all the quantitative requirements. This pillar aims to ensure firms
are
adequately capitalized with risk-based capital. All valuations in this pillar are
to be
done in a prudent and market-consistent manner. Companies may use either the
Standard Formula approach or an internal model approach. The use of internal models
will be subject to stringent standards and prior supervisory approval to enable a
firm
to calculate its regulatory capital requirements using its own internal model.
Pillar 2 imposes higher standards of risk management and governance within a
firm’s organization. This pillar also gives supervisors greater powers to challenge
their firms on risk management issues. It includes the Own Risk and Solvency
Assessment (ORSA), which requires a firm to undertake its own forward-looking
self-assessment of its risks, corresponding capital requirements, and adequacy of
capital resources.
Pillar 3 aims for greater levels of transparency for supervisors and the public.
There
is a private annual report to supervisors, and a public solvency and financial
condition
report that increases the level of disclosure required by firms. Any current
returns
will be completely replaced by reports containing core information that firms will
have to make to the regulator on a quarterly and annual basis. This ensures that a
firm’s overall financial position is better represented and includes more up-to-
date
information.
Solvency II 8
Current RBC Model Solvency II Internal Model
Methodology Static factor model Dynamic cash-flow model
Rule vs. principle based Rules-based,
except variable annuities
Principles-based
Total balance sheet approach No Yes
Definition based on market or book
values
Book value Market value, i.e., economic balance
sheet created
Classification of available capital No Yes, economic value of assets and
liabilities
Consideration of off-balance-sheet items No Yes
Time horizon 1 year 1 year, with planning cycle for ORSA
Risk measure No risk measure Value at risk/99.5 percent confidence level
Operational risk Not explicitly (implicit via business risk) Explicitly modeled
Catastrophe risk Not specifically identified and considered
in NAIC formula
An important shock component of the
insurance risk component
Correlation among risk categories Only considered correlation for credit
risk and reserve risk; square root formula
assumes other risk components are
independent
Consider correlation within and across
risk categories
Consideration of management risk No, but future linkages between risk
assessment and capital impact are being
considered under the SMI initiative
Yes
Comparing U.S. and EU systems
While both Solvency II and the RBC standards in the United States share the
common goals of protecting policyholders and strengthening insurers through
sound regulation, they are very different. Like Solvency II, the NAIC’s Solvency
Modernization Initiative (SMI) program is seeking to make enhancements to the
current RBC regime. Some key differences include:
9 Solvency II
The devil is in the detail
Pillar 1: Demonstrating adequate financial resources
Pillar 1 outlines the quantitative requirements and aims to ensure firms are
adequately capitalized with risk-based capital. Under Solvency I, capital
requirements
are determined based on profit and loss account measures (premiums and claims).
In contrast, Solvency II adopts a balance sheet focused approach, with the SCR
consisting of a series of stresses against the key risks affecting all balance
sheet
components (assets, as well as insurance liabilities), together with a charge in
respect
of operational risk.
Technical provisions in respect of insurance liabilities will in the future be
based
on discounted best estimates of expected future cash flows, with assets and
noninsurance liabilities included on a market consistent value. This comprises the
economic balance sheet (EBS) against which the components are stressed to assess
the SCR requirements. Importantly, Solvency II requires an assessment of the
balance sheet’s ability to withstand a 1-in-200-year event, so the EBS becomes
the cornerstone of all Solvency II reporting.
Capital (termed Own Funds under Solvency II) starts with the excess of assets over
liabilities as determined by the EBS. Qualifying subordinated debt is then added to
this and the combined amount is known as Basic Own Funds (BOF). There is an ability
to apply for regulatory approval to include some forms of off-balance-sheet finance
as
additional components of Own Funds (so-called Ancillary Own Funds (AOF)).
The whole amount is classified into tiers of Own Funds. Restrictions are applied to
limit the extent to which the various components of Own Funds can be used to meet
the capital requirements. The quantitative requirements under Pillar 1 can
effectively
be broken down into six components:
1. Valuation of assets and liabilities – In providing its advice to the European
Commission regarding the valuation bases to apply to arrive at a market
consistent valuation of assets and liabilities (other than technical provisions),
the Committee of European Insurance and Occupational Pensions
Supervisors (CEIOPS) has tried to harmonize its recommendations
with existing fair value options within International Financial Reporting/
Accounting Standards (IFRS/IAS), as far as possible, in order to ensure that
Solvency II 10
The whole amount is classified into tiers of Own Funds.
these items are valued consistently across all member states. Some
of the valuation bases mark a significant departure from the current
accounting valuations and/or the Solvency I treatment.
2. Technical provisions – Under Solvency II, major changes are proposed
to the valuation of technical provisions and the impact on reserving
processes will be significant. The valuations will differ significantly
from the current accounting valuation bases. The calculation of
technical provisions will be based on their current exit value. They will
be established as best estimate liabilities plus a risk margin, except
in the case of hedgeable risks arising from (re)insurance obligations.
With respect to hedgeable risks, the value of technical provisions is
calculated directly, as a whole, and derived using the values of those
financial instruments. With respect to nonhedgeable risks, the risk
margin is calculated using the so-called cost-of-capital method. In this
case, the cost-of-capital rate used is the same for all undertakings
(e.g., fixed percentage) and corresponds to the spread above the riskfree
interest rate that a BBB-rated (re)insurance undertaking would be
charged to raise eligible own funds.
3. SCR – Under Solvency II, the EEA insurers will have to calculate both
assets and liabilities on a market-consistent basis, as well as MCR
and SCR. The SCR is a more risk-sensitive and sophisticated approach
to calculating solvency requirements, which will be more dynamic
and is designed to project the economic balance sheet in one year’s
time following a 1-in-200-year loss event occurring. The SCR covers at
least the major risks, insurance, market, credit, and operational risk,
and will take full account of any risk mitigation techniques that can be
demonstrated and would be applied in times of stress. The SCR may
be calculated using a standard formula set out in the Directive or by
using an internal model preapproved by the regulator for this purpose.
4. MCR – While the SCR remains the target capital requirement under
normal market conditions, the MCR is also included. MCR is designed
to be the lower solvency calculation, corresponding to a solvency
level, below which policyholders and beneficiaries would be exposed
to an unacceptable level of risk, if the insurer were allowed to continue
its operations.
11 Solvency II
5. Own funds – BOF is the excess of assets over liabilities as determined
by the EBS with any qualifying subordinated debt added back. Some
forms of off-balance-sheet finance may receive regulatory approval to
qualify as AOF. Both BOF and AOF are allocated to tiers of Own Funds
depending on prescribed criteria, and the SCR and the MCR both have
rules regarding the extent to which the tiers of Own Funds can be
used as coverage of these requirements.
6. Investments – Under Solvency II, there are no prohibitions on
classes of assets, but, for all assets held, insurers need to be able to
demonstrate that they comply with the prudent person investment
principles (PPIP). The PPIP requirements start from the premise that
an insurer should be free to invest in any assets it chooses, provided
that it fully understands the risks involved, makes proper provision
for these (via the SCR), and that investment decisions are made
in the best interests of the policyholders. These requirements will
necessitate a change in the way assets are considered, both before
acquisition and during the lifetime over which they are held.
Figure 3: Pillar 1 components
Ancillary own
funds Surplus
Solvency Capital
Requirement (SCR)
Minimum Capital
Requirement (MCR)
Best estimate
Technical provision
Risk margin
Own funds
Basic own
funds
Assets covering
technical
provisions,
MCR, and SCR
It is expected that, in general, the SCR set by an internal model will provide a
better
reflection of an insurer’s individual risk profile, which is the incentive for
insurers to
develop their own internal models. However, in allowing the use of an internal
model,
the regulators need to understand that it does properly cover all of the risks and
is
calibrated appropriately. The methods of calculating both SCR and MCR using the
standard formula are under debate and will be finalized by the European Commission
based on the outcome of the series of Qualitative Impact Studies (QIS).
Solvency II 12
Environment
Validation/
reassessment
Infrastructure
Process
Strategy
Business objectives
and strategy Risk strategy Value proposition Risk appetite
Risk awareness/
Identification
Risk assessment/
Response Operations Reporting Measurement and
Control
Organization and
people
Culture Training Communication Performance measures Reward
Limits and controls Methodologies Systems Data Policies Reporting
Figure 4: Risk management system
Pillar 2: Demonstrating an adequate system of governance
Pillar 2 is concerned with imposing high standards of risk management and
governance within a firm’s organization. This pillar also requires supervisors to
challenge firms on risk management issues and look at the qualitative aspects of
a firm’s risk management and internal control systems. There will be qualitative
requirements for risk management systems in insurance companies to clearly set
out the requirement for an independent risk management function.
The framework in Figure 4 highlights some ideas of what Pillar 2 might entail.
According to this framework, qualitative requirements will be based on three core
strategic issues:
1. An overall responsibility of leadership for risk management
2. A clearly defined risk strategy which is linked to the business strategy
3. An ongoing management and control of the company’s risk-bearing capacity.
At the organizational level there will be various requirements. A key issue at this
level will be the requirement for core functions and processes to be established
to support a sound risk management system, i.e., risk management, actuarial,
finance and, internal audit functions, and internal control, and ORSA processes,
with the board having the ultimate responsibility for compliance over all three
pillars. This list might not be comprehensive, but considering the importance of
these processes for insurance companies, this would seem to be a reasonable
assumption. Internal audit is a key area of development since all risk-related
processes will be subject to the activities of internal audit, to ensure they are
operating as intended.
13 Solvency II
Risk management will be another essential issue, and this is the area where
Pillar 1 and Pillar 2 will really meet. It is important to note that at this point,
Pillar 2 has the potential to take an even more overarching view of risk than
Pillar 1
does, which will result in a more extensive list of risk categories to be covered
as
compared to Pillar 1.
Under Pillar 2 of Solvency II, it will not be sufficient for insurance companies
to simply execute their core competency, i.e., manage their retained risk.
The organizational setup and all the processes relating to management of the
business environment have to be documented and formalized in order to be
communicated to a supervisory authority. From KPMG’s experience, the following
areas can frequently require improvement. This list is by no means exhaustive.
1. Governance, responsibilities, and strategy:
• Comprehensive documentation of the business strategy
• Clear governance setup including a split of responsibilities across core
functions listed above
• Articulation of risk strategy aligned to business strategy
2. Independent and objective risk management function:
• Design of core processes with regard to their transparency and
formalization;
but also, the alignment of certain processes will have to be improved
• Integration of risk controlling (both quantitative and qualitative) into the
business management processes
• Alignment of activities of internal audit, especially around internal model
validation
3. Link to quantitative issues from Pillar 1:
• Alignment of methods of risk measurement and risk controlling
• Development and documentation of a concept for the risk-bearing capacity of
the firm
Additionally, this pillar requires a firm to undertake its own forward looking
selfassessment
of its risks, corresponding capital requirements, and adequacy of
capital resources. This is through the setup of the ORSA process, which requires
firms to undertake their own assessment of their solvency and financial position.
It also covers the way supervisory reviews will be carried out. Essentially, the
ORSA is an internal risk assessment process designed to ensure that senior
management has conducted their own review of exposed risks and to assess
their own solvency needs. The ORSA should be an integral part of managing
the business against the company’s chosen strategy and it should thus be an
important tool in assisting strategic decision making.
Solvency II 14
Pillar 3: Public disclosure and regulatory reporting requirements
Pillar 3 aims to achieve greater levels of transparency to their supervisors and
the public so that firms are more disciplined in their actions. This pillar focuses
on disclosure requirements to ensure the transparency of the regime and that
supervisors have the necessary information to ensure compliance with Solvency II.
There is a private annual regular supervisory report and a public solvency and
financial condition report that increase the level of disclosure required by firms.
This includes an annual Solvency and Financial Condition Report that will contain
key quantitative information. From a practice perspective, the scope of tasks
under the Pillar 3 umbrella ranges from defining and updating company disclosure
policy and technical requirements, to completing documentation of Solvency II
procedures and the implemented reporting cycle run.
Figure 5 below provides the outline of the depth of these annual disclosure
requirements.
In addition to recognizing key differences between Solvency II and its much
compared counterpart Basel II, it’s important to point out that there’s a lot of
blending between the Solvency II pillars, creating a holistic approach.
The Directive’s pillars are constructed to have a direct linkage to proper
oversight and governance of capital and risk and performance management—
an appropriate linkage that is embedded throughout the business.
As part of Pillar 2, the Directive also includes a Supervisory Review Process
(SRP).
This will be carried out by the supervisory authority in reviewing insurance and
reinsurance undertakings. The aim is to ensure compliance with the requirements of
the Directive and to identify companies that have potential financial or
organizational
weaknesses that could increase risks to policyholders. The SRP will also be
undertaken at group level. In an effort to enhance the SRP, the Directive offers
incentives to supervised institutions to better measure and manage their risk
situation.
The SFCR and RTS will contain a number of pre-defined sections, The SFCR is in
effect a subset of the RTS which includes some additional sections:
Report to supervisors (RTS)
Solvency and Financial Condition Report (SFCR)
Internal model
(when applicable)
Disclosures on result
of the internal model
Business and performance Future developments
Capital management Explanation of variance
to plan
Balance sheet Financial and non-financial
objectives
Risk management Legal and regulatory issues
System of governance Business and risk stragies
Likely to be published on
firm’s website in standard
web format
The RTS will include these additional
sections to the SFCR. It will be issued
as a private report to the supervisor
15 Solvency II
Uncovering the benefits of
strategic implementation
Even though the overall insurance industry’s solvency may not change significantly,
the
adoption of an integrated risk approach is a major change compared to Solvency I.
Far
from being merely a technical compliance issue, Solvency II could have major
commercial
implications in areas ranging from pricing and product design to investment
strategy and
market communications. Solvency II could indeed provide clear competitive
advantages for
European insurers by simplifying access to each other’s markets and providing
incentives
for improved risk measurement and management. Some of these include:
Product pricing and design
While Solvency I does not take into account the different underwriting risks,
Solvency II will
require adequate capital backing of all the risk features of the product, by
requiring insurers
to have a greater understanding of their risks and updating the models to reflect
these risks.
This will make transparent which products or product features are relevant for the
insurer’s
solvency position and which are not. From the underwriting perspective, products
with the
following features may need to be backed with more capital:
• Products with high volatility of claims
• Long-term products that are heavily discounted
• Products with guarantees and options exposed to changes in underwriting or
financial risks
Investment strategy
The potentially greatest and most obvious impact of Solvency II will come from the
introduction of capital requirements for investment risks. Solvency I (as well as
the U.S. RBC
regime) deals with investment risk only in the form of rules for the investment of
asset-backing
technical provisions. The new capital charges for investment risks may encourage
insurers to
take less investment risks than under Solvency I, i.e., they may reduce their share
in equities
and property within their investment portfolio and increase their share of higher
rated fixedincome
securities to reduce capital requirements. This would need to be balanced with the
current capital base, potentially lower investment returns, and if the investment
strategy is
not changed, the additional capital charges imposed under Solvency II leading to
reduced
overall profit. Investment risks are particularly important in long-term business,
such as life
and disability insurance. In practice, the change in prices or product design will
depend on the
extent to which insurers have already incorporated investment risks, though these
will need to
be viewed now through a Solvency II lens.
Solvency II 16
Risk transfer mechanisms
Under Solvency II, all risk mitigating instruments, such as reinsurance, hedging,
and securitizations,
need to be treated in a consistent manner. For these to be accepted as risk
mitigation instruments,
Solvency II requires that insurers quantify their actual contribution to risk
reduction. Solvency II is
likely to accept a wider spectrum of risk-hedging and risk transfer instruments,
than Solvency I, which
only permitted a uniform reduction for the use of reinsurance. The new options will
give insurers an
incentive to optimize their risk transfer solutions and may consequently intensify
competition among
providers of various solutions.
Reserving
Technical provisions are the largest item on an insurer’s balance sheet. Under
Solvency II, the
reserving risk, i.e., the risk that technical provisions will not be sufficient,
has to be backed up by a
capital charge. Technical provisions are currently taken into account by aligning
the capital requirement
to the reserves and/or capital at risk. Going forward, the need to factor reserves
into the solvency
calculation according to their risk profile makes it necessary to estimate the
expected value and
volatility of future payments. Market-consistent valuation of reserves, under
Solvency II, is expected
to enhance the transparency of reserves, and therefore, facilitate understanding of
reserve risk.
This is likely to encourage more adequate reserving on the one hand and possibly
reduce the
cyclicality in technical provisions on the other. However, it may also have an
impact on products with
potentially high volatility of technical provisions and high runoff margins. These
products may increase
in price or have to be redesigned.
Organizational impact
The Solvency II requirement of an enterprise-wide risk framework and associated
focus on product
design and risk transfer/management strategies are also likely to have an influence
on insurance
market structure. Solvency II will require a more formal approach to governance,
organization, and
decision making that necessitates insurers to demonstrate that risk awareness has
been embedded
into the fabric of the business. The framework will also require more complex and
extensive analysis,
along with a more systematic approach to risk management, which is likely to
increase demand on
actuarial and risk management functions. Companies will also need to look at how to
coordinate
actuarial, finance, risk management, and wider business functions more closely. In
particular, the
data and analysis used in the solvency calculations will need to reflect the
strategic and management
approach being adopted within the business, and vice versa. To sustain market
credibility, investor
relations teams will also need to ensure that financial and regulatory disclosures
are compatible and,
where they are not, explain why. Ultimately, as part of the “fit and proper” rules,
boards will need to
understand, endorse, and challenge what could be new and unfamiliar quantitative
and qualitative
information as part of their responsibilities as managers of the business and
policyholders’ interests.
17 Solvency II
Realizing the impact on the
United States and the world
While Solvency II will cause a transformational shift in the way the insurance
industry operates in Europe, it will also have wide-ranging implications on a
global scale. A trend of regulatory harmonization is already emerging, with other
countries seeking to achieve equivalence to Solvency II through the adoption of
risk-based regulatory frameworks. Switzerland, Bermuda (larger insurers only),
and Japan (for reinsurance only) are among those countries considered for
equivalence in the first wave of assessments based on three equivalence levels.
These levels include group supervision, related third-country undertakings, and
reinsurance (this is considered further below under “Achieving equivalence”).
In the absence of an equivalent regime, for the United States, group supervision
and related third-country undertakings hold the greatest impact. Under Solvency
II, group supervision is triggered by the existence of an EU insurance company
being owned by a foreign parent company or group of companies. The intent
of Solvency II’s group supervision requirements is to protect the policyholders
of European insurers from the risks associated with the wider group of which
they are part, either due to the level of group connectivity or due to insufficient
coverage of the group’s insurance risks with readily transferable capital—in
other words, the ability to identify the key group risks that are so material that,
if
improperly managed, can bring the group down, and hence, affect the European
policyholders. It also requires that proper governance and controls are in place at
the solo supervisory and group supervisory level.
Stopping short of requiring overseas companies to meet all of Solvency II
requirements, countries still face a complex process in demonstrating equivalent
risk and control processes. The EU requires the ability to understand the key risks
facing an organization as well as the controls and processes that are in place to
manage those risks in addition to proving capital adequacy to cover those risks. It
factors in three major components:
• Establishing the main intergroup transactions that exist between the
overseas
organization and the European entity
• Determining the key group risks that could potentially impact the European
entity
18
• Identifying the shared services provided to the European entity and the
plans in
place to ensure Solvency II compliance from those services.
Regardless of whether the parent company is located in the United States or
another country, global insurance firms with operations in Europe will need
to demonstrate to a group regulator that their group properly measures and
manages risk and is sufficiently solvent in a way that does not pose a risk to
European policyholders. This would provide the lead regulator in Europe with an
internal upward look throughout the organization all the way to the top. The
insurer
would need to demonstrate to their lead regulator that they have some line of
sight, according to the group’s supervisory requirements within the directive. If
the group is unable to satisfy the group regulator, they could end up facing having
a capital add-on directed at the subsidiary in Europe.
Conversely, in the absence of equivalence, U.S. companies that are subsidiaries
of a European parent will need to be consolidated with their European
counterparts and the Solvency II groups requirements applied to the consolidated
position of the overall European parent. For “major” (i.e., significant to the
group)
non-European subsidiaries, this is likely to have significant risk management,
data,
and system implications.
As Europe pushes forward with Solvency
II, the United States is also forging ahead
with the NAIC’s SMI, which began in June
2008. According to the NAIC, the SMI is a
critical self-examination of the U.S. insurance
solvency regulation framework and includes
a review of international developments
regarding insurance supervision, banking
supervision, and international accounting
standards and their potential use in U.S.
insurance regulation.
The NAIC has established an SMI Task Force,
which will recommend areas of improvement
for the U.S. solvency framework, and in
doing so, is looking at RBC requirements,
group solvency regulation, ORSA, corporate
governance, risk management, statutory
accounting, and financial reporting and
reinsurance.
Following the NAIC Spring 2010 meeting in
Phoenix, Arizona, the SMI reported that the
RBC requirements implemented in the 1990s
were still held to be a necessary component
of U.S. solvency regulation, but refinements
would be considered to the formula. More
advanced methods such as modeling would
be introduced for risks where factor-based
methods were not sufficient.
The SMI is the largest reform of the U.S.
regulatory system since the introduction of
RBC in 1994. Such reform has been partially
driven by international developments,
including the solvency and group changes
promoted in Solvency II.
U.S reform: The Solvency Modernization Initiative
“The SMI is the largest reform of the U.S. regulatory system
since the introduction of RBC in 1994. Such reform has been
partially driven by international developments, including the
solvency and group changes promoted in Solvency II.”
Solvency II 18
19 Solvency II
For a start, any changes in their risk profile may have the potential to
significantly
impact the parent group’s overall risk profile. Secondly, the size of data feeds
necessary to perform the detailed calculations may render it more practical to
undertake a lot of the work at the local level. There may, however, be some risks
that are specific to the entity that it may be easier to deal with at the local
level.
This raises the obvious question of “What type of rippling effect will this have
for the domestic U.S. insurers playing either in the local or global markets?”
given that a number of U.S. subsidiaries of EU parents are likely to require,
and global EU insurers are required, to implement Solvency II, specifically
an ORSA. As outlined previously in “Uncovering the benefits of strategic
implementation,” the by-product of Solvency II may well provide European
insurers with a competitive advantage in the global or domestic marketplace
as a result of increased transparency and an integrated view of risk, capital,
and performance. On the other hand, will the potential increased regulatory
capital requirements (as opposed to internal economic capital requirements)
prove to be a disadvantage by eroding profits? It is still too early to tell what
the true impact of Solvency II will be on the international insurance market;
however, a number of forward-looking international insurers have already
started developing some of the functionality inherent within Solvency II to
gain a competitive advantage over their rivals.
Article 262
Worldwide
Calculation
– Solvency II
Basis
EEA
Calculation
– Solvency II
Basis
– Hard Test
Top Insurance
Parent
Company
(Not in EEA)
Intermediate
Insurance Parent
Company
(Within the EEA)
UK Insurer
Services
Provided by
Worldwide
Group
Group
Transactions
Group Risks
EEA Sub
Group High Risk
Non EEA
Group Supervision: Solvency II
– Non EEA Parent, Not Equivalent
Group Supervision: Solvency II
– Non EEA Parent, Not Equivalent
Article 262 offers scope for a pragmatic approach
Solvency II 20
Achieving equivalence
It is not anticipated that the United States will be assessed for equivalence in
the
first wave of assessments due to its state-specific structure and lack of a central
supervisory regulatory authority. Nevertheless, there appears to be political
will to find an appropriate solution to enable the United States to be treated as
equivalent for the purposes of Solvency II. It has been suggested that the freedom
for local regulators to carry out their own assessments in the absence of anEIOPA
assessment will mean a number of individual jurisdictions will recognize the
United States as equivalent, thus giving it de facto equivalence status. In this
context, the European Insurance and Reinsurance Federation has warned EIOPA
that it must take a coordinating role to ensure that group supervisors reach the
same
conclusion on a jurisdiction.
In addition, exclusion of the United States from the initial assessments increases
the urgency for EIOPA to set out clear transitional provisions. Omnibus II allows
for
transitional arrangements to be put in place for third-country regimes not assessed
in the first wave of equivalence but treated as if they were. Yet, the criteria and
the
countries for application of these transitional arrangements are still being
decided.
While it is unclear if the United States will qualify for such transitional
provisions,
it will likely include some countries previously identified as important markets,
i.e., Australia, Brazil, Canada, China, India, South Korea, and Turkey. It is also
not
yet clear whether the United States will be the subject of transitional provisions
on equivalence. Those selected will likely need to be capable of meeting the
equivalence assessment criteria by the end of the transitional period, which may
be too difficult a time frame for the United States to complete. In practice, the
importance of the U.S. market may lead to a bespoke approach being adopted.
21 Solvency II
Understanding an evolving process
Solvency II will be implemented as EU legislation. Since 2001, the EU has sought
to effect financial services legislation though a standard framework, termed the
“Lamfalussy Process,” which is a four-level approach toward developing financial
industry regulation. It is designed to foster a more efficient and rapid
legislation
process through consistent interpretation and convergence of supervisory
practices. The Commission will then rely on consistency being achieved between
the states through a process of supervisory cooperation and peer review.
The Lamfalussy process2
contains four levels:
Level 1 – Primary legislation
This defines a proposal’s broad principles. Solvency II’s level 1 is the “Solvency
II
Framework Directive,” formally entitled the “Directive on the taking up and pursuit
of the business of insurance and reinsurance.”
The Framework Directive was proposed by the European Commission and then
was adopted under the “codecision procedure” involving both the European
Council and the European Parliament on April 22, 2009. Once it is in force, EU
member states must amend their national legislation to reflect the Directive by
the specified deadline, which currently stands at January 1, 2013. However, the
latest draft of the Omnibus II directive issued this month, June 21, 2011, endorses
the widely expected delay of Solvency II, pushing the go-live date back to January
1, 2014. Omnibus II is still awaiting final approval by the European Parliament and
the Council.
The Framework Directive will replace the EU’s existing 14 insurance and
reinsurance directives.
Level 2 – Technical implementing measures
These are more detailed requirements. Solvency II Level 2 implementing
measures will be adopted by the European Commission, on the basis of advice
formulated by the CEIOPS. CEIOPS was recently replaced by EIOPA, one of three
newly formed EU regulatory bodies (see sidebar). Solvency II implementation
2
http://www.fsa.gov.uk/Pages/About/What/International/european/lamfalussy/index.shtm
l
22
measures will spell out the detailed requirements that insurers must meet. The
more detailed legislation may then be endorsed by a qualified majority of member
states. To prepare for Level 2 implementation, the European Commission had
CEIOPS run a series of QISs. To date, there have been five QISs: the most recent,
The development of Solvency II is moving
forward but is also very much still a work in
progress. This is evident by the EU’s introduction
of three new European supervisory authorities,
including EIOPA. EIOPA is part of the European
System of Financial Supervision consisting of
three European Supervisory Authorities (ESAs)
and the European Systemic Risk Board. It is an
independent advisory body to the European
Parliament, the Council of the European Union,
and the European Commission.
EIOPA is granted extended powers under
the Omnibus II Directive, a new directive
published by the European Commission that
proposes revisions to Solvency II. Omnibus
II makes changes to existing legislation to
enable supervisory convergence under the new
European regulatory architecture. It sets out the
scope of how the new ESAs will exercise their
powers, including their capacity to develop draft
technical standards and settle disagreements
between national supervisors.
EIOPA replaces the CEIOPS—marking a
developmental shift from regulatory framework
to the beginning stages of implementation and
supervision. CEIOPS, which acted in an advisory
capacity in the development of the Solvency II
regulation and framework, was instrumental
in carrying out a series of QISs. The studies,
which resulted in valuable input from voluntary
European insurers, were designed to help calibrate
the solvency standard and provide insight into
the economic consequences on the insurance
industry, financial markets, and policyholders.
Frankfurt-based EIOPA, along with local
regulators, will now help develop and support the
implementation phase of Solvency II. According
to its Web site (https://eiopa.europa.eu/home/
index.html), EIOPA’s core responsibilities are
to support the stability of the financial system,
transparency of markets and financial products, as
well as the protection of insurance policyholders,
pension scheme members, and beneficiaries.
EIOPA prepares for the future
“Solvency II will be implemented as EU legislation. Since
2001, the EU has sought to effect financial services
legislation though a standard framework, termed the
“Lamfalussy Process,” which is a four-level approach
toward developing financial industry regulation. ”
Solvency II 22
23 Solvency II
QIS5, ran from August to November 2010. When conducting a QIS, CEIOPS created
detailed technical specifications and asked insurers to report the implications for
their
financial positions of complying with those specifications.
Level 3 – Cooperation between national supervisors to ensure harmonized outcomes
National supervisory authorities work together to provide advice to the Commission.
The Level 3 committees also aim to foster supervisory convergence and best
practice, principally through the creation of (non–legally binding) guidance.
Level 4 – Postimplementation enforcement
After the deadline for implementation, the European Commission is responsible for
ensuring that member states are complying with the legislation. If they are not
doing
so, the Commission will take enforcement action.
While the Lamfalussy process provides a good outline, the development of Solvency
II is clearly an evolving process that is constantly changing. As more consultation
is
conducted with the market, more insights are gained, and new opportunities and
challenges are revealed, and new ways of working will continue to be developed in
an effort to achieve the best possible outcome. A good example is the creation of
EIOPA as a European-wide formal regulatory body with actual powers, which was
never envisioned within the Lamfalussy process. EIOPA has much wider powers
than CEIOPS had and also has more clarity to its role, which includes the power to
set binding technical standards and settle disagreements between regulators. In
fact, according to the Omnibus II, EIOPA must develop the draft technical
standards,
including templates and structures for disclosures, by the end of this year.
The Omnibus II remains a draft Directive, but since it is the legal instrument for
making changes to Solvency II, any changes to its proposals provide good evidence
of current thinking regarding Solvency II development.
The European Council has issued three revised versions of Omnibus II this month
(June 2011), the latest of which was issued on June 21, 2011. The last of these
contains the anticipated delay to the implementation date for Solvency II.
Key dates within the June 21, 2011 version of Omnibus II are as follows:
• Member States to transpose the requirements into national law by March 31, 2013
• Provisions apply from January 1, 2014
• Articles relating to supervisory approvals become effective from July 1, 2013,
although any decisions made are not effective before January 1, 2014
• Firms must provide their supervisors with “an implementation plan providing
evidence of progress made” by July 1, 2013.
Solvency II 24
Area
QIS 5
Level 1
(Omnibus II
amendments)
1/19
OII draft
released
1/26
End of policy
consultation
6/30
Draft Level 2
text CP
11/30
Level 2 +
delegated acts
approved
12/31
EIOPA submit draft
ITS TO Commission
6/30
Final Level 3
guidelines 1/1
Current
Go-Live 6/21
OII draft
released
3/31
Member
States to
transpose to
national law
7/1 Firms submit
implementation plan
7/1
Articles for
supervisory
approvals
1/1
Proposed New
Go-Live date
3/31
ITS approved
2/28 4/15
4/15 7/15
7/15
3/15
ECOFIN
First
discussion
3/31
Q IS 5 Report
Ongoing Key
Stakeholders + Expert
Group discussion
EIOPA Preconsultation
Commission
approval
Compliance &
Enforcement
EC max 3
months
EIOPA development of draft
technical implementing standards
EIOPA formal consultation + development of
Level 3 guidelines
Consultation, redraft,
negotiation with EP
and Council
Allowance for
delay
Allowance
for
objection
Redraft
Redraft
Redraft
5/17
ECOFIN
Second
discussion
7/11
ECON/EIOP
Single
reading
1/151
EP Plenary
session
2/28
Implementing
technical
standards (ITS)
and Level 3
guidelines
Level 2
Level 4
June 21
Omnibus II
revision
*Refer to page 23 for descriptions of each level.
Aggregation of
results
Q1 2011 Q2 2011 Q3 2011 Q4 2011 Q1 2012 Q2 2012 Q3 2012 Q4 2012 SII live Q1
2013
Q2
2013
Q3
2013
Q4
2013
The European and local regulators positions remain unclear regarding implementation
timing. It should be noted that there is no material change to the underlying
principles
to implementation requirements. We suspect firms will continue to push forward with
implementation.
The key dates of the Solvency II time line in the run up to implementation, prior
to and
following the proposed June 21, 2011 version of the Omnibus II change, are shown
below.
25 Solvency II
Solvency II will foster a holistic and forward-looking appreciation of risk within
the European insurance industry. It is intended to assist in the enhancement of
the functioning of the insurance market discipline by increasing transparency
and disclosure. Overall, it should improve the international competitiveness of
European insurers and increase their operational efficiency by setting a
worldleading
standard that requires insurers to focus on managing all of the risks facing
their organization.
Solvency II should provide the right balance between risk taken and performance
incentives through a better reflection of risk management. This should also foster
innovation in product development that brings together customized products with
manageable risk features. Hence, Solvency II will reinforce insurance companies
focus on economic value creation linked to strong risk management.
Even though Solvency II is a regulatory change within the EU, it is likely to have
an impact globally, not least for non-EU parents of EU subsidiaries and non-EU
subsidiaries of EU parents, by potentially driving increased operational efficiency
in the domestic insurance market and raising standards and expectations around
risk and capital management.
In conclusion, with Solvency II meeting its objectives of a healthy insurance
industry, it is likely to bring with it some business benefits to the insurer
through
the creation of a framework that consistently reflects economic principles,
strong governance and risk management, recognition of diversification benefits,
allowance for risk mitigation techniques, risk adequate pricing, and reliance on
market mechanisms through increased transparency via public disclosures.
Summary
Solvency II 26
Adjusted SCR – The Solvency Capital Requirement level that includes any
supplementary capital
requirement determined through the Solvency II’s Pillar 2 Supervisory Review.
AOF – Ancillary Own Funds (see Own Funds)
Best estimate liability – The expected or mean value (probability weighted average)
of the present value
of future cash flows to settle contract obligations, projected over the contract’s
runoff period, taking into
account all up-to-date financial market and actuarial information
BOF – Basic Own Funds (see Own Funds)
CEIOPS – Committee of European Insurance and Occupational Pensions Supervisors
EBS – Economic Balance Sheet – A balance sheet statement based on one of those
accounting
approaches using market-consistent values for all current assets and current
obligations relating to inforce
business.
EEA – European Economic Area
EIOPA – European Insurance and Occupational Pensions Authority
FASB – Financial Accounting Standards Board
IECR – Internal Economic Capital Requirement – the company management’s internal
estimate of capital
need.
IFRS – International Financial Reporting Standard
Glossary
27 Solvency II
Internal model – A model that meets Solvency II’s requirements of the following
six tests: statistical data quality standards, calibration standard, validation
test,
profit and loss attribution, use test, and documentation standards.
Lamfalussy model – Four-level approach for developing financial industry
regulation which is designed to foster rapid legislation and consistent integration
across all EU territories.
Market value margin – Risk Margin, when added to the best estimate of
liabilities, produces a market consistent valuation of insurance liabilities.
MCR – Minimum Capital Requirement – the minimum level of regulatory capital.
NAIC – National Association of Insurance Commissioners
ORSA – Own Risk and Solvency Assessment – An assessment of an insurer’s
processes and procedures used to identify, assess, monitor, manage, and report
the short- and long-term risks it faces or may face and to determine the own funds
necessary to ensure that its overall solvency needs are met at all times.
Own Funds – Capital, as described under Solvency II. Basic Own Funds (BOF) is
the excess of assets over liabilities as determined by the EBS with any qualifying
subordinated debt added back. Some forms of off-balance-sheet finance may
receive regulatory approval to qualify as Ancillary Own Funds (AOF). Both BOF
and AOF are allocated to tiers of Own Funds depending on prescribed criteria, and
the SCR and the MCR both have rules regarding the extent to which the tiers of
Own Funds can be used as coverage of these requirements.
Pillar 1 – The portion of Solvency II focused on all the quantitative capital
requirements, which cover market-consistent valuations of assets and liabilities,
calculation of available capital, capital requirements, and internal model
validation.
This pillar aims to ensure firms are adequately capitalized with risk-based
capital.
All valuations in this pillar are to be done in a prudent and market-consistent
manner. Companies may use either the Standard Formula approach or an internal
model approach. The use of internal models will be subject to stringent standards
and prior supervisory approval to enable a firm to calculate its regulatory capital
requirements using its own internal model.
Pillar 2 – The qualitative requirements, which covers the principals of internal
control, governance, risk management, ORSA process, and supervisory review
process. The portion of Solvency II focused on imposing higher standards of risk
management and governance within a firm’s organization. This pillar also gives
supervisors greater powers to challenge their firms on risk management issues.
It includes ORSA, which requires a firm to undertake its own forward-looking
self-assessment of its risks, corresponding capital requirements, and adequacy of
capital resources.
Solvency II 28
Pillar 3 – Market discipline, which covers disclosure requirements, both private to
the supervisors and public to the marketplace. The portion of Solvency II that aims
for greater levels of transparency for supervisors and the public. There is a
private
annual report to supervisors, and a public solvency and financial condition report
that increases the level of disclosure required by firms. Any current returns will
be
completely replaced by reports containing core information that firms will have to
make to the regulator on a quarterly and annual basis. This ensures that a firm’s
overall
financial position is better represented and includes more up-to-date information.
PPIP – Prudent Person Investment Principles – The PPIP requirements start from
the premise that an insurer should be free to invest in any assets it chooses,
provided that it fully understands the risks involved, makes proper provision for
these (via the SCR), and that investment decisions are made in the best interests
of the policyholders. These requirements will necessitate a change in the way
assets are considered, both before acquisition and during the lifetime over which
they are held.
QIS – Quantitative Impact Studies – A series of exercises to test the financial
impact and suitability of proposed Solvency II requirements on firms.
RBC – Risk Based Capital – Represents an amount of capital based on an
assessment of risks that a company should hold to protect customers against
adverse developments.
RTS – Report to Supervisors – A report submitted to the supervisor that contains
information considered necessary for the purposes of supervision.
SCR – Solvency Capital Requirement – The risk-based level of regulatory capital.
SFCR – Solvency and Financial Condition Report – Public disclosure report
required to be published annually by insurers and will contain detailed
quantitative
and qualitative elements.
SMI – Solvency Modernization Initiative – A U.S. initiative being driven by
the NAIC to examine and modernize the U.S. insurance solvency regulation
framework. It includes a review of international developments regarding
insurance supervision, banking supervision, and international accounting
standards and their potential use in U.S. insurance regulation.
SRP – Supervisory Review Process – A process that enables the supervisory
authority to continuously evaluate an insurer’s relevant regulatory requirements.
Standard Formula – A non-entity-specific, risk-based mathematical formula used
by insurers to calculate their Solvency Capital Requirement under Solvency II.
Technical Provisions – The amount that an insurer needs to hold in order to meet
its expected future obligations on insurance contracts.

Solvency II
The new prudential regulation
of the insurance sector: a simplified guide
www.ivass.it
Via del Quirinale, 21
00187 Roma - Italia
Phone: +39 06 421331
Web site: http://www.ivass.it
Project and layout: Lucia Carenini
Illustrations: Cinzia Leone
All rights reserved
Reproduction of this document is permitted
for educational purposes, but not commercial
purposes, and the source must be cited
Published online in November 2016
Contents
PREsentATION 03
FROM SOLVENCY I TO SOLVENCY II, A LONG JOURNEY
What are the solvency requirements used for 04
How we were 05
The transition towards the new regulation 06
THE NEW PRUDENTIAL DISCIPLINE - PRINCIPLES
The concept of risk 07
The black swan 08
A scale always in balance 09
A building that rests on three pillars 10
The role of supervision changes 11
A system consistent with international accounting principles 11
THE FIRST PILLAR: TWO CAPITAL REQUIREMENTS
How to calculate technical provisions 12
The risk tree 13
The Solvency Capital Requirement (SCR) 16
A system of variable geometry 18
SCR coverage 19
The Minimum Capital Requirement (MCR) 20
THE SECOND PILLAR: THE CONTROL SYSTEM
The importance of corporate governance 22
The centrality of the Board of Directors and “the appetite for risk” 23
The role of Orsa 24
Stress test 26
THE THIRD PILLAR: ALL THE INFORMATION TO REGULATORS AND MARKET
The market discipline 27
Information to the market 28
Information to the supervisors 29
WHAT CHANGES FOR CONSUMERS 30
1

Presentation 3
Brief guide to the new world
From January 1, 2016, the insurance supervisory system in Europe, and
therefore Italy, has adopted a new paradigm.
In summary, it is defined as a risk-based system, since it focuses the attention
of the supervisor, as well as undertakings and the market, on the quality and
quantity of risk that each undertaking assumes through its commitments
towards policyholders, and of investment of financial resources.
Naturally, it is difficult to maintain that the concept of risk represents an
innovation of finance, of the economy and of people’s daily lives, after much
uncertainty and difficulty in the past decades and most of all, after the
immense financial-economic crisis that broke out in 2008 throughout the
world.
However, as one may guess, a supervisory system, especially if it is of
continental dimensions, is like a large transatlantic ship that, to change
route, needs an ample period of time and space to manoeuvring that
requires the entire crew to not only take the right route, but also to search
for it while the weather outside is inclement and the ocean buffets the ship.
That’s how it was.
The European Parliament approved the new Solvency II regulation in the
Spring of 2009, after a preparatory period of nearly a decade.
Important corrections to the original Directive were introduced in 2014, in
the light of the bitter experience of the global crisis.
In the course of 2015, the system was completed: the European Commission
submitted the delegated Acts of Solvency II to the Parliament and the
Council, while EIOPA, the European Supervisory Authority, proposed
technical implementation standards to the Commission, and issued the
numerous Guidelines for the practical application of the new regime.
The result of this large change is summarized here in an intentionally
lesstechnical
way, and hopefully accessible to the world of stakeholders, which
today also includes, considering the importance of insurance contracts in
everyday life, the vast public of common citizens.
In these junctures, the press, and in general, journalists, have an important
role, since they perform an irreplaceable daily activity of information
dissemination and public education, both in a direct way, explaining arriving
news, and in an indirect way, when using new criteria to read and interpret
market data.
Our hope is that this guide is an effective help to understand and make
others understand the “pillars” of the new system and the concepts that
it adopts. While aware of the inevitable applicative difficulties and areas
for improvement, Solvency II provides new and more focused lenses to
analyse the insurance world, prevent crises, and protect policyholders and
beneficiaries.
IVASS Board of Directors
salvatore rossi
The Director General of the Bank of Italy
and President of the Institute
for the Supervision of Insurance - IVASS
Riccardo Cesari
Board Member of the Institute
for the Supervision of Insurance - IVASS
Alberto Corinti
Board Member of the Institute
for the Supervision of Insurance - IVASS
From Solvency I to Solvency II,
a long journey
What are the solvency requirements used for
The undertakings, and in general, all human activities are exposed to risk
of failure. We hope it doesn’t happen, naturally, but it may. The shock
wave may remain within the boundaries of a family or small business, or
extend to undertakings with thousands of employees whose jobs are at
risk. In finance, then, defaults may have catastrophic consequences. The
insolvency of a bank, for example, may put the savings of current account
holders at risk, and produce incalculable damage to the economy of a
territory. The same thing happens for insurance, whose business, after all,
is founded on a promise: to repay in the future, in the form of capital or
service, money received from the policyholder at time of stipulation of the
contract. In a developed society, such as that in Italy, the insurance umbrella
is so ample that should an undertaking go bankrupt, the impact would be
quite grave. In 2015, for example, policies were sold in Italy, with a value of
approximately €147 billion.
The savings, pensions and true wellness of millions of people rest on those
promises. It is precisely the centrality that banks and insurers take on in a
modern society that justifies the imposition of capital requirements. That is,
the obligation of the undertakings to constantly maintain adequate capital
correlated to the risks inherent with their business. For the insurance sector,
especially, it is necessary to keep in mind the specificity of its work, and the
way with which its balance sheets are written. Premiums collected from
policyholders do not appear as assets in the accounts of an undertaking.
That money, for the most part, fuels the technical provisions of an insurer,
that is, the obligations taken towards customers at the moment of
underwriting a policy.
While waiting to return the money to the client, in the form of a payment for
a claim, or capital released at the end of the term of a life insurance policy,
the insurer invests those resources to preserve and grow their value. But it is
not assured that all investments are successful, therefore, notwithstanding
the diligence of a company in the calculations of its commitments and the
allocation of the relative resources, there is the risk that, over the
The key word
Solvency
Ability to face
assumed commitments
Le regole
1. Undertakings shall
establish technical
provisions which must
be such that they can
meet any insurance and
reinsurance obligations
arising from insurance
contracts towards
policyholders, beneficiaries
and those entitled to
insurance benefits, in
compliance with the
provisions established by
IVASS regulation.
2. Undertakings shall
hold technical provisions
the value of which shall
correspond to the current
amount undertakings
would have to pay if they
were to transfer their
insurance and reinsurance
obligations immediately
to another insurance or
reinsurance undertaking.
(Art. 36-bis Code
of Private Insurance)
INVESTMENTS LIABILITIES Compensations MEDICAL COSTS MOTOR LIABILITY INSURANCE
Life insurance
policies
The Numbers
The insurance market in Italy
Premiums collected in 2015
Non-life business € 32 bln
of which:
Motor liability insurance € 17 bln
Life business € 115 bln
Total € 147 bln
The rules
4
ASSETS LIABILITIES
ATTIVITÀ RISERVE TECNICHE
ATTIVITÀ RISERVE TECNICHE Compensations MEDICAL COSTS MOTOR LIABILITY INSURANCE
Life insurance policies
Net assets
A simplified Guide to Solvency II 5
The trade of
insurance gives
great security to
the fortunes of
private people, and
by dividing among
a great many that
loss which would
ruin an individual,
makes it fall light
and easy upon the
whole society. In
order to give this
security, however,
it is necessary that
the insurers should
have a very large
capital.
Adam Smith
(The Wealth
of Nations, Book V,
Chapter 1, Part III)
“
course of years, the insurer is required to put hand to wallet to replenish its
resources. This happens because the claims have been more costly than
previously assumed, or because a part of the investments used for covering
technical provisions has evaporated due to the negative performance of
financial markets.
Well, these examples demonstrate the importance of having capital
buffers, to use them in times of need. It is an awareness that has always
accompanied the history of the insurance industry.
Not surprising, consequently, that for many years the laws or regulations
of many countries have required the companies to equip themselves
with specific financial safeguards: the so-called technical provisions
(commitments), investments dedicated to their coverage and the so-called
solvency requirement (solvency margin in Solvency I, or Solvency capital
requirement in the new language of Solvency II).
How is the requirement calculated?
How we were
For thirty years, until December 2015, the amount of the solvency margin
was determined following the rules of Solvency I. In practice, it was
calculated, in life business, as a percentage of mathematical reserves. In
non-life business, as a percentage of annual premiums or the average
costs of accidents. That mechanism had the merit of simplicity, crowds of
consultants and actuaries were not required to determine the margin. On
the other side, however, there were evident limits. Those capital buffers
did not take financial risks into account, which may notably influence the
performance of an insurance undertaking and, in some cases of adverse
performance, even bring it to ruin.
Certainly a prudential discipline with fixed “weights”, not connected with
the performance of the main company variables, was not able to perform
an adequate alert function, also with the goals of timely and effective
supervisory action. In addition, Solvency I designed a patchy regulation
on the European continent. EU directives provided the reference scheme,
the minimum level of harmonisation for the area of the Union, but then
each country was free to decide on their own the actual solvency margin
calculation method. There was, therefore, the real danger that an “un-level
playing field” could favour some countries, to the detriment of others. Not
to mention the consequences created by the growing internationalisation
process of the insurance industry, with the birth of more groups with
presences in multiple countries, obliged to respect the most varied
prudential regulations while, through the European passport, their policies
had free access in the continental market.
The decision was made to change path, to achieve a maximum
harmonisation of the European regulation that - it was the main goal
of European legislators - closely connected the definition of capital
requirements to the characteristic risks of an insurance undertaking.
In November 2003, the European Commission instituted a permanent
committee with the mandate to draw up a draft framework law for risk
management in the insurance sector. It was the beginning of a long journey
that ended twelve years later with the entry into force of Solvency II.
The quotation
“
The key word
Welfare state
is a characteristic of the
modern constitutional
states, that are founded
on the principle of equality,
from which derive the aim
of reducing inequality
and providing
and guaranteeing rights
and social services.
The transition towards the new regulation
Such a long legislative journey is justified by the complexity of the technical
problems faced to process the new insurance undertaking risk metric. As
for the various languages that live together in the European Union, the
“language of risk” is also affected by the history of the individual countries
where the insurance industry was born and developed.
It is the result of their peculiarities and different welfare state systems.
Combining these distinct realities by finding the maximum common
denominator in the unique European context has required a laborious march
towards compliance. It is a journey that, because of the tensions created by
the sovereign debt crisis of the two years of 2010-2011, also ran the risk of a
dangerous stop. The complexity of the European legislative system, in which
the directives and their connected measures had to take a long and tortuous
journey before coming to light, must also be considered.
Actually, the Solvency II directive was definitively approved by the European
Parliament in 2009. That text contained the general principles of the future
regulation: calculation methods of the new capital requirements, guidelines
on corporate governance and risk control of insurance undertakings,
disclosure obligations. Another step forward was taken with the Omnibus II
directive (2014), adapting, among other things, the prudential rules to the
new supervisory rules determined by the birth of EIOPA that, since January
1, 2011, has had the task of monitoring the continental policy market, in
coordination with the national Authorities. Delegated acts were subsequently
issued, and as a result the technical measures indispensable for the launch of
the new prudential regulation system took form. Finally, on January 1, 2016,
the new discipline entered into force, and Solvency II replaced the 14 previous
directives and 28 national regulations, which were substituted by a single
regulation for the entire European Union area.
Solvency II - The stages
2009 - European Parliament
and Council approve Solvency II
2014 - European Parliament and
Council approve the Omnibus II
directive that amends some
aspects of Solvency II
2014 - European Parliament
approves the Regulation with the
applicative measures of Solvency II
2015 - EIOPA (European insurance
regulator) publishes its guidelines
for implementing Solvency II
(Feb. 2015- Sept. 2015)
2016 - January 1: Solvency II
enters into force
6
The concept of risk
Solvency II is, as previously stated, a prudential regulation born with the
objective of measuring every significant risk to an undertaking, with the aim
of determining the amount of capital necessary to avoid that, should the risk
materialise, the insurer fails.
To understand how the new discipline “works”, it is necessary, first of all, to
be familiar with the concept of risk, or rather, the probability that the feared
event occurs. Here we run into the first difficulty. If what may happen in the
future is the subject of our worry, the compass that we need to have some
practical indication is, however, oriented towards the past.
One cannot do without. Precisely from there, from the past, the
useful teachings to face the coming risks arrive.
It is a “science” that the insurance industry, used to
covering personal and company risks, has learned
well. To correctly calculate, for example, the tariff of
motor liability insurance, an insurer must estimate
the number of accidents that a vehicle may cause.
This pushes the insurer to study the frequency
of crashes in the past, and their average cost.
Moreover, to have some additional indication
on the risk to cover, it articulates general
indicators with more specific parameters, such
as driver age, the region where the vehicle is
registered, and so on. At the end of this analysis, the
insurer is able to formulate a hypothesis on the possibility that
the claim may be repeated, and at what cost.
This is, of course, an estimate based on the
assumption that the past is almost equally
repeated. Something that, naturally, doesn’t
always happen. When an unexpected fact
happens, this “becomes past”, and is therefore
incorporated into the prior analysis,
in the expectation that the next unexpected
event imposes a revision of the estimate. It’s
not the best case, naturally. It would be easy
for the insurers to have a crystal ball, but, after
all, if a similar forecasting instrument existed, there
would be no need for insurers.
What happens with motor liability insurance can be replicated for
all risks that an insurer is used to covering, and also for financial
risks that affect its business. There is not always historical data
sufficiently established to support an analysis on the probability of an
event. This is the case, for example, of so-called “emergent risks”, that
is, those imminent dangers whose morphologies and dynamics are not
well known. Cybernetic risks, electromagnetic storms, climate change
effects, natural disasters: in these cases, in which statistics give a
more limited support, the development of mathematical models built
The new prudential discipline
The principles
??
Stime
incidenti
auto
A simplified Guide to Solvency II 7
on certain assumptions help. The result doesn’t change: even in these cases,
associated with certain risks, we have a probability of occurrence, and an
estimated claim cost.
The black swan
The new prudential regulation has been constructed with the goal of
covering all imminent risks on the business of an insurer, within an interval
of probability of 99.5% per year.
In practice, only extreme cases have not been taken into consideration,
which have been assigned a very slim chance of happening, not more than
0.5%. If the events perfectly followed the probability distribution, it might be
concluded that the new prudential monitoring system has been designed to
limit the possibility of bankruptcy of an undertaking to once every 200 years
(1 in 200 makes 0.5%).
However, the reality is not so predictable, as gamblers well know, who
learn at their own expense how ruinous it can be to blindly trust the linear
progression of frequencies. In addition, there is another aspect to keep
in mind. Often those extreme cases, so rare, have the biggest impact on
the stability of an undertaking. They are the so-called “black swans”, as
the Lebanese mathematician Nassim Taleb has defined the completely
unexpected events, which, conversely, periodically happen with catastrophic
consequences. The financial crisis, which began in 2008 with the insolvency
of American sub-prime mortgages, is precisely one of these cases, and,
eight years later its consequences are still felt. One may conclude that if the
regulation is not able to protect the undertakings from the most ruinous and
unexpected events, it fails in its main goal. But this is not the case. Having
placed risk at the centre of the
business of an undertaking
represents an epochal change
in the supervisory discipline.
Insurance undertakings have
always been used to measuring
risks, but in this new regulatory
framework, they shall undergo
a strict discipline: the more
risks they decide to cover with
their policies, the more capital
they will have to have. All
this, as we will see in detail,
is accompanied by a much
more pervasive internal control
system, and an increased
accountability of the corporate
bodies.
Expected probability distribution
The distribution of the probability of economic loss Probability
Net asset value variation (ΔNAV)
SCR
0,5%
8
A scale always in balance
If the previous supervisory legislation was founded on a given amount of
capital to drawn upon when necessary, Solvency II, rather, designs a system
in constant balance between risks and capital requirements. It is a dynamic
balance, because the risks, and the necessary financial assets to confront
them, are realities in constant change, and require frequent adjustments. This
guide often refers to a scale to represent the concept of balance on which
the new system has been built.
In its ordinary business, an insurer calculates, first of all, the obligations
taken with the policyholders (the technical provisions) and checks that it has
sufficient financial resources to be able, when necessary, to respond to those
obligations, such as reimbursing an accident, or paying the capital of an
expiring life insurance policy. In the first place, such resources are made up
of policy premiums collected at the time of stipulation of an insurance policy,
and calculated on the basis of the probabilities. However, unexpected events
may happen that change the expectations, and which make the bill higher.
The imposition of prudential capital requirements responds precisely to the
need that the undertaking is not unprepared to face similar adversity.
The new regulation has been constructed subjecting every important
aspect in the life of an insurer to the most varied stress scenarios. “If this
particular circumstance happens – it is the question that the regulators asked
themselves - how much capital should the insurer have so as not to almost
certainly fail (that is, in 99.5% of cases)?”
A risk may hide on the side of technical provisions, for the eventuality of
reimbursing accidents for a higher amount than initially estimated. Or even
on the opposite side of the investments destined to cover those obligations,
subject to the fluctuations of financial markets. This is how to determine, for
each aspect of the insurance business, on both sides of this imaginary scale, a
specific capital requirement. The sum of various “bricks” represents the total
Solvency capital requirement (SCR) of the undertaking. That is, the capital to
hold in order to face unexpected events that may happen.
ASSETS LIABILITIES
ATTIVITÀ RISERVE TECNICHE
ATTIVITÀ RISERVE TECNICHE Compensations MEDICAL COSTS MOTOR LIABILITY INSURANCE
Life insurance policies
Assets The “technical
provisions”, or rather, the
obligations taken towards
the policyholders, are
covered by appropriate
assets on the other
side of the scale. In
case of unforeseen
events - and the SCR of
Solvency II is needed to
calculate their potential
impact - these amounts
are covered by the
undertaking’s own funds.
SCR
Solvency
capital
requirement
Ow
n fu
nds
(N
AV)
Core Financial
Statements
A
s
s
e
t
s
Assets
T
e
c
h
n
i
c
a
l
P
r
o
v
i
s
i
o
n
s
liabilities
NAV*
* or net assets (balance)
A simplified Guide to Solvency II 9
A building that rests on three pillars
The “home” of Solvency II has been built on three pillars. The first one
sets the quantitative requirements of the new supervision system. It
doesn’t monitor only the capital, but also the correct evaluation of all the
obligations towards policyholders, the diversification of investments and their
consistency with the liabilities and with the “appetite for risk” defined by the
senior management, the profitability and sustainability over time of products
offered, the ability to mitigate the technical and financial risks.
The solvency of an insurance undertaking is, however, an even wider
concept. It is obtained by complying also with qualitative requirements - the
second pillar of Solvency II - which relate to the corporate governance and
the functionality of the boards of directors; and with disclosure requirements
and comparison with the public - the third pillar.
The key word
Market consistent
valuation
The assets (liabilities)
shall be valued at the
amount for which they
could be exchanged
(transferred or settled),
between knowledgeable
and willing parties in a
transaction under normal
market conditions.
The three pillars of Solvency II
Pillar 1
Group supervision
QUANTITATIVE
REQUIREMENTS
- Valuation of
assets and
liabilities, and
investment rules
- Technical provisions
(Scr and Mcr)
- Eligible capital
(own funds)
Market consistent
valuations
Use of
internal models
More sensitivity
to risks
Pillar 2
QUALITATIVE
REQUIREMENTS
- Governance
- Risk management
(including orsa)
- Prudent person
principle
Culture
of risk
New challenges
for the supervisor
More rigour
and European
harmonisation
Pillar 3
Reporting
- Transparency
and disclosure
- Supervision
through market
support mechanisms

Pressure
from
the capital
market
More market
transparency and
discipline
The three pillars of Solvency II
10
The role of supervision changes
In the new context of Solvency II, the role of supervision also changes, called
upon to constantly follow company choices and examine the most difficult
decisions. An important aspect of the new regulatory context regards the
function of transparency. The information flows of the undertaking towards
the market and the supervisor become an essential aspect of the control
system. It is not a foregone conclusion. The aim of transparency and company
stability may also diverge where, in a situation of difficulty, the undertakings
are tempted to hide their problems from the market and supervisors out of
fear that complete sincerity may accelerate the crisis. Solvency II overturns this
argument and the lever of transparency is used in a proactive approach to
the prevention of company crises. “Obliged” to provide adequate information
to the market and supervisors, the undertakings must follow a much greater
discipline in their business choices, conditioned by that type of external control.
A system consistent with international accounting standards
Finally, the consistency of the new prudential supervision discipline
cannot be neglected, with the international accounting criteria used to
write consolidated accounts of insurance undertakings. In both cases, the
“market” valuation (market consistent) becomes the only unit of measure. In
this case too, Solvency II takes a significant step forward with respect to the
previous regulation.
The new system, as we will see in detail, establishes that technical provisions
and assets representing them are estimated by their “present” value to show
their intrinsic coherence.
Just one reality, and different ways to represent it. There is not just one way to
“read” the performance
of an insurance undertaking. In relation to their goals, and to the evolution of
the accounting
regulation, different types of accounts, applied to the same entity, may produce
different “pictures”.
There is the annual (or individual) financial statement, that is used to pay taxes
and distribute earnings.
It is written according to the national accounting standards. When multiple
companies contribute
to forming a single group, a consolidated financial statement is also drafted,
which follows different
standards, the international accounting standards (International Accounting
Standards - IAS - or
International Financial Reporting Standards - IFRS) and it is more widely used by
investors to compare
the performance of companies located in different countries. Finally, there is the
reading of Solvency
II that, in truth, represents, rather, a methodology to verify whether a company is
economically solid
enough to withstand an unexpected shock. The differences? In the balance sheets of
Italian companies,
some accounting items are, still today, valued at the lesser between the purchase
price and the market
value of an asset, adhering to the prudential standard that has historically
characterised the national
accounting standards. With regard to the provisions, in line with the same
prudential standard, the
“ultimate cost” of an accident shall be calculated, that is, how much will be
effectively paid by the
insurer at the moment of its liquidation. Important differences, up to possible
“inconsistencies”, in the
reading of the balance sheets may be even more pronounced when, in the consolidated
balance sheet,
instead, international accounting standards are applied which means the prevalence
of the market price
over the prudential criteria. It must also be added that a process of gradual
convergence with a new
international standard on insurance contracts (IFRS 4) is proceeding; this should
incorporate many of the
methods of Solvency II into the consolidated accounts to value technical
provisions.
Pay attention to... all the insurer financial statements
A simplified Guide to Solvency II 11
The first pillar:
two capital requirements
The heart of the new supervisory system is obviously represented by the
method of measuring risks and calculating capital requirements of an
insurance undertaking. Having illustrated how Solvency II is set up, now it is
time to more closely observe its operating mechanism, from new criteria to
calculate technical provisions, to the analysis of the most varied insurance
risks, to the calculation of the requirements.
The insurer balance sheet according to Solvency II
How to calculate technical provisions
Solvency II has defined a precise method to calculate the value of
the technical provisions, that is of the obligations taken towards the
policyholders, that appear as debts in the liabilities of the financial statement
of an insurer. How much are those debts worth? The reply of the regulator
is very simple: the value of the technical provisions corresponds to the actual
amount that the companies would have to pay if they were to immediately
transfer those obligations to another insurer.
SCR on the basis of asset and liability elements
subject to a specific risk
Assets Liabilities
Own
funds
Market Consistent
valuation
PPP (Prudent
person principle)
investment rules
Greater freedom,
but greater
responsibility
Excess of
assets on
liabilities
Other
liabilities
Technical
provisions
Subordinated
liabilities
Risk margin
Best
estimate
TP as
a whole
Ancillary
own
funds
Basic
own
funds
12
The key word
Discounting
In finance, the term
indicates the financial
process that allows the
determination today
of the present value of
capital that has a natural
expiration date in the
future; through the
application of a discount
rate, one may identify
the financial equivalence
between two capitals
with different expiration
dates.
Example: the present
value of 100 after seven
years at the 3% rate is
100
1,037
= 81,3
The present-actuarial
value takes also account
of the probability of the
death of the subject. If
this is 9%, in 7 years, it is
100
1,037

x (1-9%) = 74,0
Even if the principle is easy, the calculation may, however, be quite complex.
First of all, the “best estimate” of future payments is determined. Let’s
imagine, for example, to value the insurance provisions of a portfolio of life
policies that expire after seven years. Well, the insurer shall estimate, year
by year, the payments due in case of lapses, or death of the policyholder,
obviously in addition to the final capital to be delivered to the policyholder at
the time of policy expiration.
All of these values should be discounted
at a “risk free” rate to obtain the present value.
The reasoning, also in this case, is easy. If the insurance contract obliges the
company to repay, for example, €100 after seven years, it is sufficient that
this company currently holds a sum that, invested for seven years, allows it
to reimburse the debt at the expiration of the contract. Now, assuming a
rate of 3%, currently the company shall have just €81 that, invested at 3%
for seven years, would become €100 at the expiration. In addition, a margin
shall be added for uncertainty, in order to cover the risk that the estimates
are not exact. That, for example, the number of lapses is higher than that
initially estimated by the insurer.
The risk tree
With the valuation of assets and liabilities at the market value (market
consistent) we have taken an important first step in the construction of
Solvency II, but now the decisive step awaits us: to identify company risks
and submit them to the most diverse stress scenarios in order to obtain the
prudential capital requirements that the insurer needs. In order to determine
a measure of risk in extreme conditions, we must again look to the past and
master the concept of volatility.
This term is used in finance to represent the greater or lesser risk of an asset
that can be derived from the trend of its prices in a time series. Volatility is
defined as the price dispersion around their average. The expression may be
abstruse, but what it means is clear, even intuitive. A stock, whose price has
varied between €2 and €20 in the last two years is, for example, considered
more risky than a bond traded in the same period between 95 and 98 cents.
That is why the regulators have estimated the effects on the volatility of
different adverse scenarios, to establish the capital requirements appropriate
to each business risk. The calculation, anyway, is not so mechanical, and
insurers have some arrows in their quivers to mitigate the potential impact of
some vulnerabilities.
Most of all, the long term of their investments spontaneously reduces
the peaks of volatility because, if measured over a long course of time,
positive phases compensate for the negative ones. Time, in the end, is also
a medicine for financial investments. In addition, the insurance industry,
in compliance with the investment prudence principle, may better mix the
portfolio to mitigate the extent of the risks.
Volatility
Measure of the
percentage variation of
the price of a financial
instrument over time. It
technically indicates the
spread of the variations
of prices around its
average. An increase in
volatility, in principle,
reflects a more nervous
and less predictable
market, and it is usually
accompanied by a
reduction of prices.
The key word
A simplified Guide to Solvency II 13
The risk tree built by Solvency II has a thick crown. Its main branches (see
figure on the opposite page) correspond to the main risks that an insurance
undertaking finds in its business. There are financial risks defined in the
different segments (equity, interest rates, currency, spreads, real estate, etc.),
and, naturally, insurance risks. Let’s see them in detail.
The financial activities represent a fundamental component of the insurance
business. As previously mentioned, the insurer’s possibility to absolve, at their
expiration, the obligations provided for in the insurance contract depends
on the quality of the investments backing technical provisions. This explains
the attention with which regulators have weighed the risks of the financial
operations, estimating the risk of instantaneous loss in case of shocking events,
associating a specific solvency requirement to each of them. Some risk
that run across entire classes of investments have also been considered,
for example, the risk of concentration in a specific asset class, or the risk of
failure. More specifically, as regards bond investments, the new regulation
requires insurers to evaluate the effects of an increase (or reduction) of the
interest rate that may reach 70% for short term expirations (up to one year).
Bank deposits are not subject to a specific rate, as long as the entire amount
is covered by a deposit guarantee system. The new discipline exempts the
bond issues of some surely trustworthy international institutions, among
which are the European Central Bank (ECB), central banks of countries of the
Euro Area and multilateral development banks, from margin requirements.
The same exemption applies to Government bonds.
Insurance risks have an important place on the risk tree, being precisely
indicated in the pages of the directive, and in many modules and submodules
of the supervisory instructions. In the life business, the risk of
a permanent and instantaneous increase in death rates (+15%) used in
the calculations of the technical provisions is weighed. If the insurer has
underwritten policies to cover the risk of death of the policyholder, that
unexpected increase in mortality would render the technical provisions of
those contracts insufficient. Solvency II also takes into consideration the risk,
fortunately remote, of a pandemic, which is the unstoppable spread of an
epidemic. The last one on record was the Spanish flu, which spread in the
wake of the first World War (1918-1920), causing tens of millions of deaths
throughout the world, more than the victims of the Great War.
The opposite risk is also evaluated, i.e. the risk of longevity, in the case
where the same mortality index undergoes an instantaneous and unforeseen
fall (-20%) compared to the estimated value: the increase in lifespan is a
risk for an insurer when a company, for example, shall pay life annuities
to its policyholders. An increase in illness and disability (+35%), too, is
taken into account when it has an impact on the value of life policies or, in
general, on contracts underwritten in that specific insurance branch. Each
cost component has been carefully analysed by the regulators to weigh
the specific risk, even that of an increase in lapses compared with the
physiological number, or an increase in costs above the estimates.
The key word
Shock events for SCR
Instantaneous reduction of
the value of a specific class of
investment as a result of a
predetermined shock
Type Shock (in%)
Shares listed
in OECD -39
regulated
markets
Shares listed
in different markets, -49
or unlisted
Strategic
equity -22
shareholdings
Financial intruments
related to goods -49
(commodities)
Alternative
investments -49
Real estate -25
Currencies -25
14
In non-life business, the risk modules that insurers shall calculate taking into
consideration all the typical risks of their business, estimating the possibility
of occurrence in relation to known historic series or, in absence of such
data, using mathematical simulations. This case covers, for example, risks
of earthquakes and other natural disasters, catastrophe caused by humans
(terrorism, for example), air plane accidents, fire and so forth. Each insurance
class has found its place in the Solvency II schemes, that have associated
each risk with an appropriate prudential requirement in relation to type,
frequency, potential impact of that particular exposure. In addition to all this,
there is always, evaluated by the regulators, the possibility that some internal
procedure goes wrong, and this is why a general operational risk has also
been included in the calculation of solvency requirements.
The risk tree in the standard formula
SCR
Basic SCR Adjustment
for the loss-absorbing capacity
Operational
risks
Market Health Default Life Non-Life Intangible
assets
Interest rates
Equity
Property
Spread
Currencies
Concentration
Health
assimilated
to life
Mortality
Longevity
Disability
Morbidity
Lapse
Expenses
Revision
Catastrophes
Health
assimilated
to Non-life
Premium
and reserve
Lapse
Mortality
Longevity
Disability
Morbidity
Lapse
Expenses
Revision
Natural
disasters
Catastrophes
Premium
and reserve
Lapse
A simplified Guide to Solvency II 15
The Solvency Capital Requirement (SCR)
By adequately mixing their exposures, insurers can mitigate the total risk of
their portfolio. For example, the risk of longevity can be tempered by
simultaneously offering policies that cover mortality risk. In non-life business,
the main risk is related to the adequacy of technical provisions, and it is
divided into many components. Each component, as we have seen in the
preceding paragraph, has its own effect on the capital requirement.
Aggregating them with appropriate correlation matrices, to take the effects
of diversification into account (see box), the Solvency Capital Requirement
(SCR) of the company is obtained. Solvency II was constructed to take a
continuously moving business reality into account. The companies shall
update the requirement calculation once a year, or more frequently if their
risk profile changes, and shall formulate their estimates using - as a time
reference - the successive twelve months from the moment of their
recognition. In any case, undertakings shall monitor their requirement on a
continual basis.
The calculation of the SCR
Assets
Own
funds
(NAV 0)
“Stressed”
own funds
(NAV 1)
Pre shock (tempo 0) Post shock (time 1)
Technical
provisions
Own
funds
(NAV 0)
“Stressed”
own funds
(NAV 1)
SCR SCR = NAV 0 - NAV 1
Assets
Technical
provisions
16
Risk diversification and mitigation
Basically, Solvency II has done nothing more than replicating and making the
“best rules” of the insurance profession systematic in its own models. Principles
of
mitigation and diversification have always been at the base of the insurance
industry.
Their importance is intuitive. If a company covers one single risk, and that event
happens, the consequence may ruin the company. If, vice versa, the same company
cedes a portion of its risks to others, the effects of that unlucky event will not
be so
deadly to its accounts. The most traditional risk mitigation instrument is
represented
by co-insurance and by re-insurance. When, for example, an undertaking ensures
an airplane - the same applies for any coverage of a significant amount - a large
part of that premium (and of the relative risk) is ceded to other companies, or to
a re-insurer, to mitigate the impact of a possible accident. Re-insurers are a
small
club, formed of companies with particularly robust economic shoulders. The three
major worldwide re-insurers cover a significant portion of risks of the entire
planet.
In that case, diversification happens within their portfolios. Let’s suppose that a
group covers earthquake risks in Latin America, Europe and Asia. Now, it is quite
unlikely that a seismic event will happen contemporaneously in these three areas,
so the diversification of that risk produces a positive result on total exposure.
Over
the course of years, the principle of diversification has been endorsed by finance.
Diversifying investments, as any good manager knows, reduces the risk of ruinous
loss. Now, also the Solvency II regulation has adopted it among its pillars. The
new
prudential discipline includes correlation matrices in its armaments, in which,
taking
into consideration the time series available, different risks are mixed together so
as to appropriately reduce the exposure of a total portfolio and the corresponding
solvency requirement. It may be observed here that the true function of the
prudential
regulation is to provide the proper incentives so that insurers follow the best
practices of their industry. In this case, the incentive represented by a reduced
capital
requirement induces the insurers to behave well.
A simplified Guide to Solvency II 17
A system of variable geometry
The path towards Solvency II has required an extraordinary organisational
effort for the insurance industry in these years, and a notable investment
of resources to establish and test the new requirements imposed by the
regulation. However, a small company that works just in one insurance
business, also from the supervisory point of view, does not have the same
needs of a large international group that is active in various businesses. For
these considerations, Solvency II allows the definition of different solvency
requirement calculation methods, to take into account the different
complexities of the company structure. An insurer may determine the
Solvency Capital Requirement through the standard formula, which has
been briefly described in these pages or, alternatively, may use an “internal
model” that better reflects its own specific risk profile. This last model
may be used for all the businesses included in the company’s perimeter,
or just part of them, to cover some risk modules or business sectors of the
undertaking.
The internal model is not simply an alternative method to calculate the
SCR. It must satisfy numerous and strict requirements demanded by the
regulation, with active involvement of the board of directors. At the end of
this path, it requires the specific authorisation of the Supervisory Authority
(IVASS in Italy) that, in case of a group operating in other countries of the
European Union, decides, together with the other Authorities involved in
group supervision.
The key word
USP: the third
way to calculate
the solvency
requirement
In the effort to adapt the
regulatory obligations to
the specific reality of an
insurance undertaking,
Solvency II has provided
an intermediate solution
for the calculation of the
solvency requirement.
Insurers that do not
intend to fully adopt
an internal model, may
still adapt the standard
formula to their business
characteristics. They may
use, in particular, their
specific parameters (USP
- Undertaking specific
parameters), calibrated to
take the relative features
of their own risk portfolio
into account, to calculate
the risk modules for
life assurance, non-life
insurance, and health
insurance. In this case as
well the undertakings
shall obtain specific
authorisation from IVASS.
Solvency Capital Requirement - Different models
Standard formula, internal models, USP
Risk
sensitivity
SCR
Internal model
Standard formula and partial internal models
Standard formula
Standard formula
with simplified methods
Standard formula with application
of specific parameters (USP)
18
SCR coverage
We are nearly at the end of our illustration of the first pillar. Once the
amount of required supervisory capital has been determined, the regulation
precisely indicates the eligible elements to cover the capital requirements. In
the first place, they are own funds of the insurance undertaking, that is, the
excess of assets (investments of the company) compared with its liabilities
(technical provisions). These resources may be summed with the subordinate
liabilities issues by the insurer. They are, in practice, bonds considered
“almost capital”. Those who buy them obtain a much higher yield compared
with that guaranteed by normal corporate bonds, but on the other side,
they are at the bottom of the creditors list, just before shareholders, in case
of bankruptcy of the company that issued them. For these characteristics,
they are assimilated - also for prudential purposes – to risk capital, with
which they share many characteristics, notwithstanding their bond nature.
The expected profits on future premiums are allowed, subject to certain
conditions, to be taken into account for the coverage of the solvency
requirement, among the own funds of an insurance undertaking.
Ancillary own fund items are subject to IVASS authorisation, and are offbalance
sheet items represented, for example, by called but not paid capital,
or letters of credit or other legally binding obligations.
Own funds - Identification
Own funds covering capital requirements are composed of:
Basic Own funds
- Excess of assets on liabilities
- Subordinated liabilities
- Adjustments in the
reconciliation reserve:
- Participations in financial
and credit undertakings
- Ring-fenced funds
- Expected profits
in future premiums
Ancillary Own funds
(subject to prior approval
by the supervisor)
- Off balance sheet items
which may be used:
- Called but not paid capital
- Letters of credit
- Other legally binding
obligations
The key word
SCR =
Solvency Capital
Requirement
Amount of solvency
capital required by the
Solvency II regulation.
SCRR = SCR Ratio
Ratio between own funds
and the SCR.
Values above 100 indicate
that the own funds are
sufficient to cover the
capital requirement.
Pay attention: sometimes
this ratio is also indicated
with the acronym SCR.
A simplified Guide to Solvency II 19
The Minimum Capital Requirement (MCR)
As we have seen, determining the standard capital requirement (SCR)
is a laborious action that requires complex calculations and rigorous
validation procedures. To manage this complexity, regulators decided it
was appropriate to establish an annual frequency for its update. This does
not negate that in the course of the year insurers must certify having at
least a minimum base of prudential capital. This function is fulfilled by the
second capital ratio provided by the regulation. It is the Minimum Capital
Requirement (MCR). It is calculated every three months, and an insurance
undertaking shall at least reach this minimum capital requirement to
continue to operate.
The mechanism for determining the amount recalls the prior supervisory
system, however adapted to the new Solvency II environment. In practice,
the minimum capital corresponds to a percentage of the own funds
of the undertaking in relation to some parameters (net premiums and
technical provisions), calibrated to take account of their risk (see figure in the
opposite page). The MCR is included between 25 and 45 percent of the SCR,
and the regulation also sets an absolute minimum level (for example, €3.7
million for life undertakings and €3.6 million for re-insurers).
Only top quality elements are eligible for MCR coverage (ex. not ancillary
own funds).
Pay attention to...
Own-funds of
Italian insurers
At the end of 2015, Italian
insurers had eligible
own funds to satisfy the
capital requirement equal
to nearly €120 billion, 2.4
times the required level
(SCR).
20
Once the rules are made, they shall be applied. The Solvency II discipline
does not limit itself to establishing the capital requirements that insurance
undertakings shall hold, but operates in an active way on the entire
company structure to ensure that the calculation and monitoring of the
prudential ratios is seen as central in the reality of a company. In the
intentions of those who designed the new regulatory scenario, the culture
of risk - which also belongs to the history of the insurance industry since
its origins - shall become the real business engine. Or better yet, this is
beyond doubt but Solvency II strives to design the appropriate incentives so
that the insurance managers are fully aware of them. The second pillar of
Solvency that deals, as already stated, with the qualitative requirements of
the new prudential system is expressly designed for this purpose.
The insurance sector is distinguished by one peculiarity: the insurer first
collects the premium, and later, even after quite a long time, provides its
service, reimbursing an accident or paying the policyholder the capital that
it committed to paying him. Economists call this the inverted insurance
business cycle, but the fact of having the customers’ money in advance
- which are debts towards them - may push managers to a risky, if not
even incorrect, behaviour: in order to achieve a greater profit, they may,
The Second pillar:
the control system
The inverted cycle of the insurance industry
Unlike what happens in the
other sectors, the insurer
first takes money, and
then provides its service,
or rather, pays claims in
case of accidents or at the
expiration of a policy.
Policyholder
Insurer
A simplified Guide to Solvency II 21
The importance of corporate governance
The new regulatory architecture, after all, is “limited” to highlighting
and making the principles already present in all the business law manuals
binding, indicating the “good rules” of corporate governance that
the insurers shall observe. The innovation is mainly in the fact that,
normally, those precepts, in addition to the provisions contained in the
civil code, are present in self-regulation codes that the undertakings are
free to accept, or not. And they are directed most of all towards listed
companies. In this case, instead, they are directly outlined in the new
regulatory discipline, almost to emphasise the special role attributed to
the insurance undertakings in function of their business. And they apply
for all companies, listed or not, large or small. The number of provisions
and procedures to observe is ample, but substantially related to some
fundamental principles.
The objective of a good corporate governance system
is to attribute precise responsibilities to each company body, and reach an
effective balance between management and control powers.
in fact, knowingly or unknowingly underestimate the risks that they will
be called on to cover in future. In a word, they could underestimate the
amount of technical provisions. The new prudential discipline, which tightly
connects the capital requirements to the insurance portfolio risks, removes
this optical illusion. It shows an insurer that taking on high risks has an
immediate cost, that of setting aside higher financial resources. And since
the capital is a limited and expensive resource - investors provide it if they
think they will be well remunerated - it is here that the new prudential
discipline “obliges” the insurers to behave well, to do the right thing.
Provided that, of course, the entire corporate structure is involved in this
process. These are the reasons why the second pillar of Solvency II is so
important.
The key word
Governance
“Member States shall
require all insurance and
reinsurance undertakings
to have in place an
effective system of
governance which
provides for sound and
prudent management of
the business. That system
shall at least include an
adequate transparent
organisational structure
with a clear allocation
and appropriate
segregation of
responsibilities and an
effective system for
ensuring the transmission
of information. [...]
Insurance and reinsurance
undertakings shall
have written policies in
relation to at least risk
management, internal
control, internal audit
and, where relevant,
outsourcing. They shall
ensure that those policies
are implemented.”
(article 41 of the
Solvency II directive)
In Italy, due to the
effect of the secondary
regulation issued by
IVASS, these precepts
have been introduced for
a long time.
22
The centrality of the Board of Directors
and “the appetite for risk”
Solvency II is engaged, first of all, in affirming the centrality of the Board of
Directors (BoD) in the management of the undertaking and in the supervision
of the internal control system. In the first place, it is the administrative body
that defines the insurer’s “appetite for risk”. The effort to know oneself
does not refer only to the nature of the company, with its competitiveness,
or with the “animal spirits” of capitalism which the English economist John
Maynard Keynes spoke about.
The Board of Directors shall perform an analytical task. Specifically, it shall
evaluate the amount of capital that an undertaking is prepared to dedicate,
or can dedicate, to risks that it has committed to covering. Knowing full
well that each of them is associated with a capital requirement, under the
Solvency II metric. It is a strategic function that requires the knowledge of
the risks and the propensity to face them, the identification of tolerance
thresholds and the definition of the maximum permissible exposure. The
strategic plan of an insurer, the choice to enter a class of insurance, or to
leave another, comes from these evaluations. At the time of Solvency II,
the careful control of risks and the more efficient dosage of capital that the
insurer has, become the main strategic levers in the hands of management.
The risk dashboard
Based on the current and forward-looking assessments of the risks, the
administrative body determines
the undertaking’s risk propensity in line with the goal of protecting its assets,
by consistently
setting the levels of risk tolerance it reviews at least once a year, to ensure
their effectiveness over time.
Risk Profile
(actual risk): the actual risk
assumed, measured in a
specific moment in time.
Risk Tolerance (tolerance threshold): the
maximum deviation from the risk appetite
allowed; the tolerance threshold is fixed in
such a manner as to ensure, in any case,
sufficient margins for the company to
operate, even in conditions of stress, within
the maximum risk assumed.
Risk Capacity
(maximum acceptable risk): the
maximum level of risk that a company
is technically able to assume without
violating the regulatory requirements
or other obligations imposed by the
shareholders or by the Supervisory
Authority.
Risk Profile < Risk Appetite < Risk Tolerance < Risk Capacity
risk indicators
Risk Appetite
(risk objective or propensity for
risk): the risk level (total, or by
type) that the company intends
to assume for the achievement
of its strategic objectives
A simplified Guide to Solvency II 23
This sort of “self-certification” is the assumption on which to build the entire
corporate structure - whose configuration is approved by the same Board
of Directors - together with risk management policies and the compliance
function that presides over respect of numerous laws and regulations which
the company is subject to. The Board of Directors also heads audit activities,
which are the internal reviews aimed at verifying that all of the company
bodies behave properly, and at discovering possible reprehensible facts.
Not only. The Board of Directors, in the Solvency II context, also approves
risk measurement and management policies, as well as contingency plans,
plans on technical provisions calculation and re-insurance and other risk
mitigation technique plans. A particularly delicate task concerns, finally, the
fulfilment of professional and good repute requirements by Board Members,
top management and persons responsible for the control functions. These,
too, are rules covered by a specific company policy approved by the Board of
Directors.
The company guidelines provided by the administrative body find application
in the entire company structure, both for management and control functions.
Once again the new discipline gives precise provisions so that each body
is invested with specific responsibilities. Among the most important news
introduced by Solvency II, there is the elimination of the appointed actuary,
replaced by a specific function in consideration of the importance that the
statistical-actuarial calculations play in the appropriate identification of
company risks.
The role of ORSA
Although the name in Italian reminds that of a constellation, in the new
Solvency II regime, that term indicates rather the North Star of controls,
the tool shared among companies and supervisory Authorities to make the
process of construction and verification of solvency requirements take place
according to a precise plan. In the context of the European legislator, ORSA,
Own Risk and Solvency Assessment, is inserted fully into the overall set
up of risk management. The Solvency II directive establishes that ORSA be
used to evaluate the risk and company solvency, that the results are taken
into consideration systematically for the strategic decisions of the company,
and that are subject to a constant communication with the supervisory
Authority. ORSA does not represent the only company management
instrument available to managers. The supervisory Authorities, too, need
it to scrutinise, in the context of supervisory processes, if the company has
correctly evaluated its risks. In a dynamic prudential discipline characterised
not by the imposition of a predetermined, or “static”, quantity of capital,
but by the analysis of a company reality in motion and with a continual
balance of economic safeguards necessary to maintain its soundness, there is
a subjective aspect to consider. Notwithstanding the rigour of the methods,
the analysis of those who estimate company risks and their coverage, may,
naturally have some errors. And, naturally, the point of view of the observer
can make the difference. In the new regulatory context, supervision plays the
role of tutor towards company practices to ensure that they are appropriate
and directed towards the best standards. Naturally, it does not replace
the management function , but it constantly follows the decision making
24
A simplified Guide to Solvency II
processes of the undertakings. ORSA, having a shared methodology for
the assessment and management of corporate risks, reduces the risks of
subjective distortion on the part of the insurer, while, from the supervisors’
side, promotes a proactive role aimed at preventing crisis situations rather
than intervening after the fact to repair the consequences.
Differently from the previous prudential supervisory system, Solvency II
does not impose quantitative limits, for example, to investments that the
companies can make. What is important is that the management is aware of
the risks of their choices, and they adopt higher risk management standards.
Prudent person principle
In particular, the undertakings must respect some fundamental principles.
For example, in risk valuation, it is necessary to adopt the “look through”
method. It is a type of lens that allows the undertaking to gain awareness
and confidence with risks that hide behind and within complex financial
structures that may become important in the presence of detonating factors.
In the subject of financial investments, the companies must respect precise
guidelines. They direct their choices to assets characterized by appropriate
levels of security, quality, liquidity and profitability. They build their plans so
that the duration and the characteristics of the investments are consistent
with the nature of the insurance obligations. Derivative products are used
only for risk coverage and a better financial management. Their use for
speculative ends is prohibited. In their decisions, the insurer must behave like
a good family father, respecting the “prudent person principle”.
As we see, these best practices are well known in the world of finance.
The novelty, as we have observed, is that Solvency II translates them into
binding behavioural rules.
NO
quantitative
limits and few
prohibitions
More risk
management
and more aware
management
of investment
risks
Prudent
person
principle
(Pillar 2)
A simplified Guide to Solvency II 25
Stress tests of European regulators
As always happens, one learns more from adversity. The 2008 financial market
crisis, followed
in 2010-2011 by the tensions in the sovereign debt of some countries in the Euro
area, has
represented a strong warning to the regulatory Authorities throughout the world.
Since then,
those who design the market supervisory regulations have tried, in the first place,
to imagine the
most distressing scenarios to check, in those stress situations, the strength of
the safety net. It has
also happened in the insurance industry, where the European authority, EIOPA, has
conducted
different quantitative exercises over the years to assess whether the capital
safeguards established
with Solvency II were sufficiently robust to survive in extreme situations. The
stress test performed
in 2014, which imagined a severe financial crisis aggravated by a prolonged
situation of low
interest rates, involved more than 55% of the European insurance market. It showed,
in general,
that the continental insurance industry was sufficiently capitalised and, in normal
situations, 86%
of undertakings were able to cover at least the SCR.
In May 2016, a new exercise was announced that seeks to enlarge the range of
European insurers
involved to 75%. The stress test will consist of evaluating the resilience of the
insurers to two
adverse financial scenarios: a first one focused on the hypothesis of a further
decrease of the
returns curve compared to year-end levels; a second one, called the “double hit”,
in which a strong
devaluation of all classes of important investments - bonds, stocks, funds, real
estate - is added to
the first scenario.
Stress test
These are simulation exercises aimed at measuring the ability of an
undertaking to face adverse scenarios. In the finance field, stress tests
are used by intermediaries to manage credit, market, operative risks,
etc., and by supervisory Authorities as an instrument of supervision. They
allow evaluations and estimates of some reliability on the sensitivity and
vulnerability of the individual intermediaries (micro-prudential goals) and the
financial system as a whole (macro-prudential goals).
The stress tests are typically created in reference to a plurality of contexts,
each characterised by a different level of adversity: for example, a scenario
of stress on the securities market may be represented by a fall in stock
quotations of -39% compared with current values. More complex scenarios
regard a plurality of risks (stocks, taxes, credit...).
The results of the simulations are represented by a measurement of the
effects that the single scenarios determine on predefined reference variables
(for example, yield, liquidity, net assets).
There are three families of stress tests to keep well differentiated in the
Solvency II world. The first is necessary to calculate the SCR.
The second is defined and used by companies in the so-called ORSA
environment. The third is established by EIOPA in the exercises that the
European regulator periodically requires insurance undertakings to perform
to verify their “vulnerability” (see box).
26
The Third pillar: all the information
to regulators and market
The market discipline
We behave better if we “must”, if someone is watching, with curious
faces, what we’re doing. In an open society, this someone, for
undertakings, is the market. The life-blood that makes external scrutiny of
the market possible is information. The third pillar of the new prudential
supervisory system of insurance undertakings has been constructed on this
basis. Beyond a more accurate method to measure company risks, and put
appropriate capital provisions in place, and in addition to an articulated
system of internal controls, market discipline has been considered a
fundamental instrument so that undertakings do not stray from the right
path, and thus avoid ending up in default.
It has already been observed that trust represents a fundamental ingredient
of the insurance business. Now, the more transparent and prepared to
provide information on itself a company is, the more its clients, investors
and creditors will be prepared to trust it and follow its path. Solvency II
outlines a dense network of information that shall constantly connect
an insurance undertaking to the supervisory authorities, and no less
importantly, to the market.
We will see in detail what these obligations consist of. What is now
interesting to note, is that the new discipline imposes a set of information
on the insurers, for quantity and quality comparable to that which
characterises listed companies.
The companies have an ambivalent relationship with information. They
need it, of course, for assessing market opportunities and building their
businesses, and are available to give it to the public when it gives prestige
to their businesses. They become alarmed, however, when they are afraid
that the information may favour a competitor (and they jealously protect
it), or in the case of “bad” news, when they believe that the spread to
the public of information critical of the company may aggravate or even
impede the solution. It is this “prejudice” that Solvency II, and the new
approach to supervisory activity in general, seeks to combat. The verb
“understand”, after all, does not only mean to know, but to “accept”,
so that the more a company can communicate the positive, and even the
more problematic aspects of its reality, the more the market is prepared
to follow it, “for better or for worse”, so to speak. From the supervisors’
point of view, in addition, having a good flow of information means to
perceive crisis factors in advance, and indicate necessary countermeasures
before the crisis explodes. In a word, to have a proactive attitude on
the theme of supervision, oriented towards prevention, more than
management, of company crises.
A simplified Guide to Solvency II 27
Information to the market
Every company is already subject to the obligation - provided by the civil
code - to publish its accounts every year. This obligation is added to the
progressively stricter standards, in case a company decides to list its stocks or
bonds in the stock market. They shall, in that case, among other things, draft
semi-annual financial statements and, in general, publish “privileged” news
regarding themselves as soon as possible (news that may have an impact on
stock prices). The identity of their stockholders, as well, is public information
when the share capital exceeds the threshold of 3%. With Solvency II, in
addition to all this, insurers will be obliged to make public, every year, a
special report on their financial condition and solvency (SFCR, Solvency and
Financial Condition Report). That document will contain information on:
1) Type of business and performance
2) Governance
3) Risk profile
4) Valuation criteria
5) Capital management
The perimeter of data subject to the transparency obligations is quite
vast. The Solvency II directive however permits some limited exceptions.
For example, when the publication of information is susceptible to giving
competitors of an insurer “significant undue advantages”. Or when the
insurer is obliged to confidentiality due to agreements with its contracting
parties. If a company is listed, a part of the information of the SFCR is
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already available to the market (such as that on corporate governance),
but, for example, on company risk analysis and the operative business of
the insurers, new regulatory obligations represent a significant step forward
in the information standards, and contribute to promoting much deeper
awareness of European insurance. It will represent a sort of litmus test of
many values of the company financial statements that, calibrated to the risk,
will demonstrate their actual consistency.
Information to the supervisors
The same information given to the market, but with a higher level of detail
and frequency, is the subject of the reports that the insurers must send
to the supervisory Authority. It is, in particular, the Regular Supervisory
Report (RSR) of a qualitative nature, produced every year, accompanied by
documents containing data on the main company parameters. The quantity
of numbers and information that shall be transmitted is significant, and
regards every important aspect of the business of an insurer.
The ORSA report is also included with the obligatory documentation, as
well as the annual accounts on how the calculation method has been
implemented, and the verification of the solvency requirement (see above).
The information to transmit to the supervisor will be provided on a regular
basis (annually, quarterly), or following a “predefined” event
or, in any case, upon request by the supervisor.
The insurer shall adopt a written policy for reporting, and use supervisory
reporting forms harmonised at a European level.
Small insurers, in compliance with the proportionality principle, may use
some exemptions from quarterly reporting obligations, or in relation to
specific requirements (for example, the detailed investment list).
Data timing
The new reporting obligations imposed on insurance companies
will need to be fulfilled within precise time limits specified by
the regulations. At the end of the transitional period, which will
end in 2020, the Solvency and Financial Condition Report, and
the Regular Supervisory Report, shall be published within 20
weeks from the date of the closure of the financial year, Annual
quantitative reports for the supervisory authorities within 14 weeks
from the date of the closure of the financial year, and quarterly
data within 5 weeks. At shorter intervals (2 weeks), supervisors
must receive the ORSA, the self-assessment on the risks and
solvency. In 2016, the year that the new regulation entered into
force, the companies had the obligation to send a prospectus
containing the valuation of assets and liabilities to IVASS within
20 weeks from the beginning of the financial year, as well as
the minimum capital requirement (MCR), the solvency capital
requirement (SCR) and the evaluation of the own funds eligible for
coverage of the capital ratios.
The key word
Predefinied event
There are events that
may substantially change
the risk profile of an
insurance undertaking.
In these cases, there is
the specific obligation to
immediately inform the
supervisory Authority.
It is naturally impossible
to predefine a complete
list of such events,
however EIOPA (the
European Insurance
Supervisory Authority)
has provided some
examples for guidance
purposes.
The predefined events
include: changes in
business strategy,
significant internal
reorganisation,
important legal cases,
significant changes in
the level of own funds
or the evaluation of
the Solvency capital
requirement, the
Minimum capital
requirement, or the
technical provisions.
New and emerging risks
are also numbered in this
same category, as well as
significant compensation
that the company is
required to pay, and
criticality in corporate
governance structure of
the company.
A simplified Guide to Solvency II 29
What changes for consumers
The new prudential discipline of the insurance industry may be considered as
a self-awareness tool at the disposal of the companies to know and better
manage the risks of their business. The capital safeguards associated to
those risks - in practice, the solvency margin of the company - represent the
indispensable corollary of the new system. The fact of placing the risk culture
as the cornerstone of corporate life - from the administrators who define the
strategies, to the managers that execute them, to those who are responsible
for the checks, and even to those who distribute the policies to the public
- designs an inherently more protected environment for the conduct of
insurance business.
Also relevant, for the undertakings as well as the consumers, is the fact of
being able to count on a system of rules that are harmonised at a European
level. The first Community directives regarding insurance go back to the
1970s (to 1973 for non-life insurance, and 1979 for life assurance), but
they dealt with general layouts, with frequent exemptions and references
to the national regulations. Successive Community regulation, in the 1990s,
conferred a European passport to authorised insurers of a member state,
allowing them to freely “export” their policies in the European Union
area. But only with Solvency II in effect, the single market of insurance
policies may finally claim to be created with maximum harmonisation of
solvency and supervisory regulations. The competition between operators
within the continent may occur based on a single set of regulations, the
same everywhere. The activity of supervision, too, has been marked with
homogeneous criteria, ensuring European consumers equal protections.
The national Supervisory Authorities - working side by side with EIOPA, the
European regulator of the insurance sector - through constant monitoring of
the insurers, may play a proactive role in impeding, and further, preventing,
company crises, which represents the final goal of the regulation. In the
new context, the supervisory activity, through the compass of company
risks, will have more effective instruments with which to do their jobs,
and obviously, consumers will also profit from the new regulatory context.
Solvency II, however, does not exhaust the effort to further strengthen the
protections. With a new Community directive (IDD, Insurance Distribution
Directive), that came about in 2015, a notable step forward was taken in
consumer protection standards in the distribution of insurance products.
The directive does not only regulate the behaviours of traditional insurance
intermediaries (agents, financial promoters, etc.), but has widened its range
to include new locations as well (supermarkets, car rental, travel agents) in
which policy offerings are developing. In the delegated acts currently under
discussion obligations will be configured that are even more stringent for
those who design the new insurance products and for those who distribute
them. It is a sort of “product governance” (Product oversight governance)
which affirms the “know your client” principle. In practice, for each type of
policy, the producer is called upon to identify a specific target client, and
the relative distribution strategy. Once again, they are marketing procedures
already in use in insurance companies but which, in this new context, should
be used by all of the undertakings, and well specified to consumers and the
supervisory authorities.
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Notes
A simplified Guide to Solvency II 31
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