On 1 January 2016, the new supervisory framework for insurance and reinsurance companies – Solvency II - became applicable. Often called "Basel for insurers", the Solvency II framework is similar to its banking equivalent Basel II, in that it focuses on the capital adequacy of the asset/liability holder and requires appropriate risk management systems.
The key objectives of Solvency II are:
- Improved consumer protection: It will ensure a uniform and enhanced level of policyholder protection across the EU. A more robust system will give policyholders greater confidence in the products of insurers.
- Modernised supervision: The “Supervisory Review Process” will shift supervisors’ focus from compliance monitoring and capital to evaluating insurers’ risk profiles and the quality of their risk management and governance systems.
- Deepened EU market integration: Through the harmonisation of supervisory regimes.
- Increased international competitiveness of EU insurers.
Solvency II represents a fundamental and wide-ranging overhaul of the current regulatory regime, affecting life and non-life insurers and re-insurers. Solvency II replaces Solvency I, which represents 14 EU Directives. Much of the Solvency II Directive consolidates existing insurance directives (namely the Life, Non-life Directive ( NLDs ), Reinsurance Directive, Coinsurance Directive, Insurance Groups (IGD), Financial Conglomerates (FCD) and Winding-up Directives) into a single directive. The rest will consist of new provisions i.e. substantial changes introduced in order to reflect the new Solvency II system. In contrast to Solvency I, Solvency II is a largely ‘maximum harmonising’ regulatory framework, which introduces a single set of requirements that will be applied consistently across Europe.
Solvency II will apply to all insurance and reinsurance firms with gross premium income exceeding EUR5m or gross technical provisions in excess of EUR25m (see Article 4 of the Directive for full details).
Solvency II adopts a ‘total balance sheet’ approach: the risks to assets, liabilities and the interactions between them need to be considered in setting capital requirements. It introduces several key features, some of which seek to ensure that firms identify, quantify and manage their risks on a proportionate and forward-looking basis.
As with Basel III, it is based around the 3 pillar structure- each pillar governing a different aspect of the requirements and approach:
Pillar 1: Quantitative Requirements: capital requirements for the firm.
Pillar 2: Qualitative Requirements and supervisory review: requirement to assess and manage risks within the firm, and prospective risk identification (ORSA) and to maintain capital sufficient for these risks.
Pillar 3: Reporting and Disclosure Requirements: report greater amount of information to firm’s supervisors and disclose publicly key relevant information which will bring in more market discipline.
Pillar 1 – quantitative requirements
Pillar 1 covers the quantitative requirements a (re)insurance undertaking (firm) is expected to meet. It sets out the rules to value the undertaking's assets and liabilities, calculate capital requirements and to identify eligible own funds to cover those requirements. It outlines the standard formula insurance companies across the European Union must use for the calculation of their capital reserves covering all types of risks.
The undertaking is required to carry out a market consistent valuation of its assets and liabilities under Solvency II, in order to determine its solvency position. It is required to establish technical provisions to cover its reinsurance and insurance liabilities (liabilities), corresponding to the current amount a (re)insurance undertaking would have to pay to transfer its liabilities immediately to another (re)insurance undertaking.
A firm's own funds form the difference between the sum of a market consistent valuation of its assets, less the sum of a market consistent valuation of its liabilities. A firm must hold a certain quantity and quality of own funds to act as an asset or capital buffer above the value of their liabilities, and provide cover against significant, adverse events which could affect the values of their assets and liabilities and consequently its solvency position.
Pillar 1 defines two capital requirements firms will have to meet:
The Solvency Capital Requirement (SCR) is the target level of capital requirements under normal conditions and will be calculated at least once a year. This is the higher of the two capital levels required in Solvency II. It can be achieved through either a standard formula approach, or based on a company specific approved full or partial internal model. If this threshold is missed the respective supervisory authority will determine supervisory responses linked to the concrete situation of the firm.
The Minimum Capital Requirement (MCR) is a function of SCR. It is a lower requirement and reflects an absolute minimum level of required capital. The capital position of the company must be monitored against SCR on a continuous basis. If the MCR is breached ultimate supervisory action will be triggered – withdrawal of authorisation.
Pillar 2 – qualitative requirements
Pillar 2 of Solvency II sets out the requirements for the governance and risk management of insurers, as well as the effective supervision of insurers. This deals with the qualitative aspects of the firm’s system of governance and consists of the following key elements:
- Risk management system – includes risk management strategy, well-defined policies and internal reporting procedures;
- Policy processes and procedures - effective internal control systems which include administrative and accounting procedures, an internal control framework, a compliance function and appropriate reporting arrangements at all levels;
- Key functions – those of compliance, internal audit, actuarial, and ensuring that all key function holders meet the fitness and propriety requirements;
- Own Risk and Solvency Assessment (ORSA) and capital management.
Own Risk and Solvency Assessment (ORSA)
Articles 41(3) and Article 45 of the Solvency II Directive require every firm to carry out a regular assessment of its solvency needs and its compliance with those needs to demonstrate “sound and prudent management of the business”. In order to implement ORSA effectively, a strategic approach is needed, requiring integration into a firm’s enterprise risk management framework. Essentially this covers five principles: identification, assessment, monitoring, management and reporting the short and long-term risk it faces or may face and determining the own funds necessary to ensure that the undertaking’s overall solvency needs are met at all times.
Pillar 3 - Disclosure and Reporting requirements
Articles 35, 51, 53, 54, 55, 254 (2) and 256 of the Directive set out public disclosure and supervisory reporting requirements for the Solvency II regime which are designed to ensure that supervisory authorities have all the information they need for the purposes of supervision.
Disclosure of information enables supervisory authorities to assess firms’:
- Systems of governance;
- Businesses they are pursuing;
- Valuation principles for solvency purposes;
- Risks faced and risk management systems; and
- Their capital structures, needs and management.
Firms must produce two key reports:
- the Solvency and Financial Condition Report (SFCR) – Firms are required to disclose this report publicly and to report it to the local National Competent Authority (NCA) on an annual basis. The SFCR includes both qualitative and quantitative information; and
- the Regulatory Supervisory Report (RSR) – This is a private report to the supervisor and is not disclosed publicly. Firms submit this report to the NCA in full at least every three years and in summary every year. The RSR includes both qualitative and quantitative information.
Quantitative Reporting Templates (QRT)
EIOPA developed and published the Solvency II Quantitative Reporting Templates (QRT) and is implementing XBRL as the standard for reporting data submission between EIOPA and NCAs and is promoting its use in the wider insurance market by providing an EIOPA XBRL Taxonomy. The quarterly templates will be considered core information and will constitute mostly point-in-time measures. Undertakings should have the quarterly quantitative templates reported to the supervisor, approved either by the administrative, management or supervisory body or by persons who effectively run the undertaking. Some of the elements of the quarterly quantitative template will be reported on a "flash" or fast-close basis and includes:EIOPA and NCAs and is promoting its use in the wider insurance market by providing an EIOPA XBRL Taxonomy. The quarterly templates will be considered core information and will constitute mostly point-in-time measures. Undertakings should have the quarterly quantitative templates reported to the supervisor, approved either by the administrative, management or supervisory body or by persons who effectively run the undertaking. Some of the elements of the quarterly quantitative template will be reported on a "flash" or fast-close basis and includes:
- the minimum capital requirement;
- the solvency capital requirement;
- some information on technical provisions and assets;
- and own funds.
Full Solvency II Reporting
EOPA's Timeline for delivery of ITS and Guidelines
The first Solvency II reporting by companies began in April 2016. The first Solvency II public disclosure began in May 2017.