Solvency II overview:
The Solvency II Directive (2009/138/EC) is a Directive in European Union law that codifies and harmonizes the EU insurance regulation. Primarily, this concerns the amount of capital that EU insurance companies must hold to reduce the risk of insolvency. With this directive, EU insurance legislation aims to unify the European insurance market and enhance consumer protection. Insurance Directives establish a single licence for insurers to operate in all member states if they fulfilled EU conditions.
Solvency II includes Risk‐sensitive capital requirements combined with best risk management practices in order to achieve consistent application across EU and consolidate all existing life, non‐life and reinsurance directives. Compare to “Solvency I” Directive, which aimed at revising and updating the current EU Solvency regime, Solvency II has a much wider scope. The main Solvency II capital requirement purposes are:
- to reduce the risk that an insurer would be unable to meet claims,
- to reduce the losses suffered by policyholders in the event that a firm is unable to meet all claims fully,
- to provide early warning to supervisors so that they can intervene promptly if capital falls below the required level,
- and to promote confidence in the financial stability of the insurance sector;
Solvency II framework is conceptually based on Basel II structure for banking sector and has three main areas, which are described in three pillars.
Pillar 1: Addresses the quantitative measures, technical provisions and capital requirements: for example, the amount of capital an insurer should hold.
Aspects of Pillar 1:
Technical Provisions valuation:
- One way to estimate technical provisions is using a market instrument, if one is available and which can simulate the cash flows under the policy;
- Second way is to combine margin required by a third‐party to take over the obligation and weighted average probability of future cash flows, discounted using risk‐free term structure of interest rates;
Solvency Capital Requirement (SCR):
- Is simply the capital required to meet the existing portfolio quantifiable risks plus the expected new business in one year time, which should be calibrated at VaR 99.5%.
Minimum Capital Requirement (MCR):
- It is lower than SCR and it is calibrated to 85% VaR over one year from valuation date. It is calculated as a linear function of some or all technical provisions, written premiums, capital‐at‐risk, deferred tax and administrative expenses.
Pillar 2: Qualitative measures, governance, risk management, supervisory interaction which sets out requirements for the governance and risk management of insurers, as well as for the effective supervision of insurers.
Aspects of Pillar 2:
- Requires insurers to incorporate effective governance system which provides sound and prudent management. This means that risk management, internal control and audit, actuarial function and outsourcing systems should be established and ensure that they operate according to the prescribed standards.
- Insurer must have own risk and solvency assessment framework, which considers the solvency needs according to the business strategy, compliance of capital requirements, any deviations from the SCR assumptions.
- Supervisors should periodically review strategies, processes and reporting procedure and assess them. Additionally, supervisors are required to review and evaluate compliance with requirements.
And Pillar 3: Supervisory reporting and public disclosure, which focuses on disclosure transparency requirements.
Aspects of Pillar 3:
- Report on solvency and financial condition should be prepared at least once a year.
- Most of the content should be public and must include description of the performance of the insurer, the government system and its quality assessment, for each risk category the risk exposure, concentration, mitigation and sensitivity, valuation methods for assets and liabilities should be presented.
- The report should also include a detail description of the insurer capital management framework. It is not necessary this part to be public.
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