Understanding Solvency II

Publication January 2014


Introduction

Solvency II will radically change the supervision of insurers and reinsurers across Europe. Under the Solvency II Framework Directive, existing insurance directives will be amended and recast in order to introduce a consistent, risk-based, solvency regime which better reflects modern solvency and reporting requirements.

The Solvency II Framework Directive, dated 25 November 2009 originally required the provisions of the new regime to be in force by the end of October 2012. A second 'Quick Fix' Directive amending the transposition and application dates of the Solvency II Directive come into force on 19 December 2013. It again extends the date by which Solvency II must be transposed by Member States into national law from 30 June 2013 to 31 March 2015.

The Solvency II regime will come into force for insurers on 1 January 2016, at which time the Solvency I regime will cease to apply.

This article tracks the progress of implementation, considers the background to Solvency II and explains how the regime will be structured. It also provides a glossary of frequently used terms and highlights some issues that need to be addressed over the next two years in preparation for full implementation.

Where are we now?

After almost a decade in the making, Solvency II will apply from 1 January 2016. According to the European Commission this is now the definitive date and there will be no further changes to the timetable. Firms must make full use of the next two years as we approach the implementation deadline.

The process towards a new pan-European solvency regime has been slow, repeatedly delayed and widely criticised. Having adopted the Solvency II Directive in late 2009, a further Directive, Omnibus II, proposed significant amendments to the Solvency II Level I Framework. Despite negotiations on Omnibus II starting in March 2012, trialogue parties failed to reach a compromise on several key features, most notably the treatment of long-term guaranteed products. Consequently, the implementation deadline was delayed to 1 January 2014.

Progress appeared to have stalled altogether over summer 2013 as commentators argued that the 2014 date was unachievable, with alternatives ranging from 2015 to 2017, or even later. The turning point came when the European Insurance and Occupational Pensions Authority (EIOPA), at the Commission’s request, carried out an impact assessment on the long-term guarantees package of measures. EIOPA’s final report was published in June 2013 paving the way for trialogue agreement on long-term guarantees and issues related to the calculation of annuity liabilities.

With January 2014 out of reach, a further 'Quick Fix' Directive was proposed in October 2013 delaying Solvency II for a second time. The European Parliament adopted this Directive on 22 November, therefore changing the transposition deadline to 31 March 2015 and the application date to 1 January 2016.  

On 13 November 2013, following months of uncertainty, agreement was finally reached between the European trialogue parties on the Omnibus II Directive and a final compromise text was published shortly afterward. The European Parliament is scheduled to vote on the Omnibus II text on 11 March 2014.

Adoption of Omnibus II is the last element needed to apply the Solvency II framework. The deal includes a package of measures to facilitate insurance products with long-term guarantees and transitional measures both for EU insurers and third countries moving towards equivalence. Insurers will continue to be able to match long-term liabilities with investments in long-term assets such as infrastructure projects. Omnibus II also contains measures to mitigate the effects of artificial volatility, such as a matching adjustment for annuity business, a volatility adjustment, extrapolation of the risk-free interest rate, transitional measures and the extension of the recovery period.

Clarity on the final provisions of Omnibus II and the implementation timetable was welcomed across the industry. The latest transposition and application dates are now unlikely to change meaning firms can resume preparation for the new regime on the basis that provisions to implement Solvency II rules into national law will be passed by 31 March 2015, and the regime will apply in full from 1 January 2016.

In anticipation of a definitive timetable, EIOPA issued preparatory guidelines aimed at assisting national regulators in assessing firms’ preparedness for the new regime. The guidelines cover: system of governance; forward looking assessment of the undertaking’s own risk; submission of information; and pre-application for internal models. The Prudential Regulation Authority (PRA) proposes applying the guidelines in a proportionate, risk-based manner according to the nature, scale and complexity of the business. As Omnibus II negotiations rumbled on, the PRA adopted its own planning period to implementation particularly in relation to firms involved in the internal model approval process.

It is worth noting that whilst agreement on Omnibus II remained elusive, work continued on global supervisory initiatives with the International Association of Insurance Supervisors (IAIS) leading the way. In the effort for global convergence of standards, the IAIS has been busy updating its Insurance Core Principles (ICPs). The ICPs act as a benchmark for insurance supervisors and encourage adaptation of national regulatory frameworks to comply with global standards. The Solvency II regime is largely aligned with the ICPs and so whilst the industry awaits implementation insurance supervisors, by conforming to the IAIS’ principles, can continue towards a global regulatory structure. The IAIS also announced plans to develop the first risk-based global insurance capital standard (ICS). The ICS will be introduced by the end of 2016, followed by two years of testing by supervisors and internationally active insurance groups.

Background to Solvency II

During 2004 and 2005 the European Commission undertook a review of EU insurance law in order to improve consumer protection, modernise supervision, deepen market integration and increase the international competitiveness of European insurers and reinsurers. Under Solvency II‚ insurers will be required to take account of all types of risk to which they are exposed and to manage those risks more effectively.

The current solvency system is over 30 years old and financial markets have developed significantly since then, leading to a large discrepancy between the reality of insurance business today and its regulation. The reforms have been driven forward as a consequence of the European Commission concluding that there are widespread divergences in the implementation of the existing insurance directives across the EU and wishing to ensure that the insurance sector has a comparable regulatory and prudential regime to that of the banking and securities sectors in the EU.

Solvency rules stipulate the minimum amounts of financial resources that insurers and reinsurers must have in order to cover the risks to which they are exposed. The rules also lay down the principles that should guide insurers' overall risk management so that they can anticipate any adverse events and handle such situations more effectively.

The new solvency requirements have been designed to ensure that insurers have sufficient capital to withstand adverse events, both in terms of insurance risk (as under the previous regime), and now also in terms of economic, market and operational risk.

Solvency II is to be adopted in accordance with the 'Lamfalussy' process. The Lamfalussy process takes a four-stage approach to the introduction of financial services regulation. In the first stage a framework directive is proposed (after a full consultation process). At stage two technical implementing measures (or 'delegated acts' under Omnibus II) are introduced; much of the detail is added at this stage. The third stage involves work on recommended guidance and non-binding standards which are not included in the legislation. Finally, the fourth stage of the process requires the European Commission to monitor compliance by Member States.

How is Solvency II structured?

Solvency II will be based on a 'three pillar' framework. The pillar system originates from the approach taken in the Capital Requirements Directive, which followed the international Basel II Accord for banks and investment firms.

Pillar 1 – minimum capital requirements

Under the first pillar insurers are required to maintain reserves against liabilities (technical provisions). A consistent market-based system is applied for assessing liabilities as well as ensuring a greater matching of assets to liabilities. Insurers and reinsurers must adhere to a Minimum Capital Requirement (MCR), which is the fundamental level of solvency required of any insurer. This has been set an absolute floor of €2,500,000 for non-life insurance undertakings, €3,700,000 for life insurance undertakings and €3,600,000 for reinsurance undertakings, except captive reinsurance undertakings which will have an MCR of €1,200,000. If the MCR is breached, supervisory action will be taken.

The Solvency Capital Requirement (SCR) represents the target level of solvency which an insurer or reinsurer needs to maintain. It is a fully risk-based calculation which can be made either through a standard formula or by using internal models (or a combination of both). Basically the SCR is the amount of capital needed to leave a less than 1 in 200 chance of capital being inadequate over the forthcoming year.

The Directive requires that insurers and reinsurers invest their assets in accordance with the 'prudent person' principle and they should invest in such a manner as to 'ensure the security, quality, liquidity and profitability of the portfolio as a whole'.

Pillar 2 – supervision of risk

Insurers will be required to submit their own assessment of risk and solvency capital adequacy (known as the ORSA). In addition, they must submit details of their internal systems and controls. The internal risk and capital review process is subject to a regulatory supervision process akin to that introduced by the Financial Services Authority (FSA) in the Individual Capital Adequacy Standards (ICAS) regime.

Should it be seen to be necessary, supervisors may require a 'capital add-on'. It might be that the supervisor will request that further capital be injected into the SCR following the review process, although this should only occur when the supervisory authority concludes that the risk-profile of the insurer 'deviates significantly' from the assumptions underlying the SCR.

Pillar 3 – public disclosure

The third pillar harmonises disclosure requirements. Insurers are required to report publicly on their financial condition, providing information on capital.

Solvency II

Quantitative requirements

  • Minimum capital requirements
    - MCR
    - SCR (Standard model)
  • Eligible capital
  • Technical provisions
  • Asset valuation

Risk management and supervision

  • Risk management
  • Internal controls
  • Corporate governance
  • Stress testing

Supervisory reporting and disclosure

  • Accounting standards
  • Regulatory reporting
  • Ratings agency review
Pillar 1 Pillar 2Pillar 3 

2012 developments

Europe

EIOPA guidelines on the ORSA

In summer 2012, EIOPA published a series of reports in response to consultations launched towards the end of 2011. Perhaps the most important of these is the report on the proposed Level 3 guidelines on the ORSA. The guidelines underline the purpose of the ORSA, provide details on how the ORSA is to be interpreted and set out EIOPA’s expectations regarding the implementation of the ORSA by insurance undertakings. EIOPA has strongly encouraged the industry to use the current report in their early implementation of the ORSA. Insurers are expected to have the necessary competence and expertise to find 'fit-for-purpose solutions' for the practical challenges of the ORSA. EIOPA points out that proportionality is a key feature of the ORSA and insurers should develop tailored processes to fit their own organisational structure and risk management systems. In addition, the undertaking’s administrative, management or supervisory body needs to take an active role in the ORSA, particularly in relation to steering how the assessment is to be performed and challenging the results. Finally, the report notes that undertakings are required to submit a forward-looking assessment of their overall solvency needs to national supervisory authorities, indicating multi-year tendencies and developments.

Third country equivalence assessments

In the final months of 2011, EIOPA also submitted to the European Commission final reports on third country equivalence assessments under the Solvency II Directive relating to Bermuda, Japan and Switzerland. EIOPA will revisit each of these reports once the final Level 2 implementing measures have been agreed in order to verify whether any amendments to the criteria change the conclusions reached. At the same time, EIOPA will consider whether any changes made to the Bermudan, Japanese and Swiss solvency and prudential regimes affect the assessments. Once the review is complete the European Commission will decide upon the equivalence of these third countries.

The European Commission has developed a transitional regime for Solvency II equivalence for third countries which either have a risk-based regime similar to Solvency II, or are willing and committed to move towards such a regime over a pre-defined period (5 years in the initial proposal). For those third countries that have indicated that they are interested in being covered by the transitional provisions, the European Commission requested that EIOPA carry out a 'gap analysis'. In February 2012, EIOPA announced that Australia, Chile, China, Hong Kong, Israel, Mexico, Singapore, and South Africa had expressed an interest in being part of the regime. EIOPA sent these countries requests for information in order to carry out the analysis. EIOPA's work is of a technical nature only. It will be up to the European Commission to decide which third countries will be included in the equivalence transitional regime. The process is subject to adoption of Omnibus II. There is no definitive date but the Commission is expected to decide on equivalence sometime in 2014.

UK 

Consultation papers

A number of UK consultations were published in 2012 which considered the rules required to transpose the Solvency II Directive. The Financial Services Authority (FSA), predecessor to the Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA), published a consultation (CP11/22 Transposition of Solvency II - Part 1) which included details of the new Prudential Sourcebook for Solvency II Insurers (SOLPRU). Transposing Solvency II into UK law also requires changes to primary legislation. The FSA launched the second consultation on transposition in July 2012. CP12/13 Transposition of Solvency II: Part 2 includes proposed rules and guidance on areas that were not covered, or were only partially covered, in the first consultation and focused in particular on: the application of the rules to the Lloyd’s insurance market; separate disclosure of capital add-ons; and proposed changes to rules governing with-profits and unit-linked business. The consultation closed in October 2012. The FCA’s November 2013 policy update indicates that feedback on both transposition consultations is expected in the first or second quarter of 2014.

HM Treasury consulted separately on legislative amendments to ensure that UK regulators have the powers necessary to implement the Directive. The consultation closed on 15 February 2012. It is unclear when the outcome of this consultation will be published.

Late in 2011, the FSA issued CP11/23 Solvency II and linked long-term insurance business. This consultation proposed changes to the FSA rules and guidance relating to the operation of unit-linked and index-linked insurance policies (primarily contained in COBS 21) to ensure consistency with the requirements of Solvency II. The feedback statement, published in June 2012, confirmed the FSA's intention to make the proposed amendments to COBS 21 and addressed some general points raised by respondents. The final policy statement to CP11/23 is also expected in the first or second quarter of 2014.

IMAP

The FSA began receiving submissions from those firms that are currently in the pre-application phase of the internal model approval process (IMAP) on 30 March 2012. Initially, the FSA had allocated submission slots to firms between 30 March 2012 and mid-2013. The FSA invited firms to consider how their Solvency II model could be used to meet the current ICAS rules, thereby removing the need for the parallel running of two separate models. The FSA also confirmed that internal model applications should be based on the Level 2 text and proposed cross-referencing the text with its guidance materials. In May 2012, the FSA published a letter to firms involved in IMAP setting out its feedback on firms' work to date. Areas of weakness identified included: methodology and assumptions; aggregation and dependency; validation; the use test; model change policy; un-modelled risk; and documentation requirements. The FSA offered additional guidance on how firms can improve their IMAP submissions and what information should be included.

In October 2012, responding to the growing uncertainty around Solvency II implementation, Julian Adams, FSA Director of Insurance, announced a change to the IMAP timetable. Adams stated the PRA, once it took charge of prudential regulation from April 2013, would adopt its own ‘sensible planning period’. The PRA’s approach, known as ICAS+, allowed IMAP firms to choose a date up to a maximum of 31 December 2015 to submit their internal models. The PRA stated that this was the most pragmatic way forward and allows firms more time to complete the work they need to do for their submissions. 

2013 developments

EIOPA preparatory guidelines

EIOPA began preparing supervisors and undertakings for Solvency II by developing guidelines covering the key areas of the new regime:

  • System of governance
  • Forward looking assessment of the undertaking's own risk
  • Submission of information to national supervisors
  • Pre-application of internal models.

EIOPA received over 4000 comments during the consultation period and issued final guidelines on 27 September 2013. The guidelines were addressed to National competent authorities (NCAs) which had to decide how best to implement the guidelines into their national regulatory or supervisory framework by the application date of 1 January 2014.

The PRA consulted on its approach to implementing EIOPA’s guidelines and, in December 2013, issued a final supervisory statement (SS4/13 Solvency II: applying EIOPA’s preparatory guidelines to PRA-authorised firms). The statement came into effect on 1 January 2014 and will cease to operate on the day prior to implementation of Solvency II, 1 January 2016.

The statement explains that the PRA expects firms to have regard to the outcomes in the guidelines whilst also continuing to meet the existing PRA rules. Whilst the guidelines are generally consistent with existing PRA handbook provisions, firms are required to implement the substantive provisions in order to ensure that they are ready for the new regime.

The PRA sought to be proportionate in its application of the guidelines to ensure that there is a minimal risk of two regimes running concurrently. For each of the four areas of preparation the statement identifies where firms need to focus their efforts and where the guidelines require more than existing PRA handbook provisions. The PRA will assess firms’ preparations in a proportionate and risk-based manner and expects firms to apply the guidelines according to the nature, scale and complexity of their business. The key issues are summarised below.

System of governance

  • Generally consistent with current expectations around standards of group governance, systems and controls and the fit and proper criteria applied to approved persons.
  • Review of existing governance and risk management systems required to take into account the greater scope and granularity under Solvency II.
  • Guidelines will assist firms in preparing their annual SFCR covering governance issues once Solvency II enters into force.
  • Organisational structure, group governance and board responsibility will need to be reviewed for compliance.
  • Firms are encouraged to review their existing outsourcing arrangements and document their outsourcing approach, including contingency plans in the event of a service provider failure.

Forward-looking assessment of the undertaking’s own risks, based on the principles for the ORSA

  • Guidelines will assist firms in designing, compiling and trialling their risk management framework in preparation for the standard expected for an ORSA from 1 January 2016.
  • Firms should have a robust process in place to assess, monitor and measure all risks and to ensure that the output from the assessment forms an important part of the firm’s strategic and decision-making processes.
  • Board involvement will be more extensive and members are expected to play an active part in how the ORSA should be designed and documented, risk identification and mitigation and approving and communicating the finished product.
  • Results and insights from the ORSA should inform firms’ capital management and business planning, as well as product development and design.
  • Two annual assessments are proposed during the preparatory phase. The second assessment is expected to be of a higher standard taking into consideration market conditions, risk profile changes and experience gained from the previous year.

Submission of information to NCAs

  • The PRA will apply proportionate, risk based thresholds for quantitative and qualitative reporting from life, non-life, individual firms and groups.
  • Firms are expected to develop systems and structures aimed at delivering high quality information for supervisory purposes.

Pre-application for internal models

  • Internal models will continue to be developed and firms with models that are sufficiently stable are encouraged to begin testing and refining their models based on experience.
  • Firms engaged in the pre-application process are reminded that it is not a pre-approval process and the PRA may not approve their model.

Long-term guarantees assessment

Summer 2013 saw EIOPA complete an assessment of the long-term guarantees (LTG) package proposed under Solvency II. Disagreement on the treatment of long-term guarantees in times of market stress had stalled EU negotiations on the final Omnibus II text.

EIOPA published the results of the LTG assessment which considered the following six regulatory measures aimed at ensuring an appropriate supervisory treatment of long-term guarantee products under volatile market conditions:

  • Adaptation to the relevant risk-free term structure or Counter-Cyclical Premium (CCP)
  • Extrapolation
  • 'Classical' Matching Adjustment
  • Extended Matching Adjustment
  • Transitional measures
  • Extension of the Recovery Period.

Based on the outcome of the assessment, EIOPA supported (subject to some minor amendments) the inclusion of the extrapolation, classical matching adjustment, extension of the recovery period, and transitional measures. EIOPA also advised the trialogue parties to replace the CCP with a formulaic, more reliable measure, known as the 'volatility balancer'. EIOPA recommended excluding the extended matching adjustment altogether, whilst retaining the 'classical' matching adjustment.

The conclusion of the LTG assessment meant that EU trialogue discussions could resume.

A turning point – the PRA approach

Late in 2013, Julian Adams, PRA Director of Insurance, highlighted some key issues concerning the progress of the Solvency II regime for UK firms. Adams encouraged firms to reassess priorities and make a concerted push to ensure compliance. The regulator will adopt an ‘intelligent copy out’ approach to its handbook, meaning it will follow the words of the Directive text as closely as possible, and may issue supervisory statements where it considers that general guidance is needed to clarify its expectations of firms.

Firms will need to continue to meet existing regulatory requirements until Solvency II is implemented. Where possible, the PRA will look for ways that firms may be able to use their preparations for Solvency II to meet the current supervisory regime. The PRA attaches considerable importance to the ORSA, describing it as the ‘cornerstone’ of the new regime. It will play a key role in supporting the threshold condition that insurers must have appropriate non-financial resources and robust risk and capital management systems

The PRA thinks it reasonable to expect firms to be ready for Solvency II based reporting six months before implementation, meaning that firms falling within the thresholds should be able to submit their reports in July 2015. The PRA will continue to review the practicability of the reporting timetable but warns firms to prepare for higher quality reports and better synchronised reporting under Solvency II. 

With transposition now set for 31 March 2015 (subject to adoption of Omnibus II), the PRA can formally approve internal models from 1 April 2015. The PRA will operate a two-stage approach to the review of IMAP technical provisions. The first stage of the review looks at the approach and methodology used by firms, and the second stage will focus on the actual calculation of technical provisions. The PRA intends to publish information in the first quarter of 2014 on the progress of the first stage as well as an update on the second stage, which has been deferred as a result of Omnibus II delays. Now that the timetable is certain, firms must be prepared for their IMAP submission slots.

Glossary of terms

Capital add-ons - Article 37 of the Solvency II Directive prescribes the limited circumstances in which a capital add-on can be applied. Supervisors can apply a capital add-on where the risk profile is not in line with that in the SCR or there are significant governance deficiencies. The right is only supposed to be used in 'exceptional circumstances'. When a capital add-on is imposed, the amount is added to the firm’s SCR to generate the new SCR for the firm. Once imposed a capital add-on is to be reviewed at least annually by the regulatory authority. If the deficiencies that led to its imposition have been remedied then the capital add-on is to be removed. The method and process for calculating and imposing capital add-ons are expected to be set out in the Level 2 legislation (and further explained in the Level 3 guidance).

Group SCR - Groups will need to calculate a group solvency capital requirement (Group SCR). This can produce a lower capital requirement than the aggregate of the individual members’ own requirements. Individual members of the group must still comply with their own solo requirements but any surplus arising only at the group level (for example, because of any diversification benefits) may be treated as additional capital for the individual group members. In addition, there are also capital instruments (for example, hybrid capital and subordinated liabilities) which will count towards the Solo SCR but not the Group SCR.

Market consistent valuation - One of the fundamental changes in Solvency II is the move to a market consistent valuation of liabilities (on the basis that your capital will never be assessed properly if you do not have a realistic view of your liabilities). The market consistent balance sheet approach is similar to the fair value reporting approach used in international financial reporting standards. In broad terms this means that insurers should value their liabilities based on expected future cash flows, discounted appropriately and, unless they can find a hedge for their liabilities, insurers must hold a risk margin to reflect the cost of capital that would be required to transfer the liabilities to a third party. As part of this process there will also be new rules on how to treat reinsurance and other risk mitigation techniques.

Minimum capital requirements - Insurers will be required to satisfy a MCR and to run their business in such a way as to also satisfy a higher capital requirement, the SCR. Breach of the MCR is designed to lead to the loss of the insurer’s licence, whereas breach of the SCR will trigger regulatory intervention in order to resolve the breach. The SCR will be calculated using either a standard formula or a bespoke internal model, or in some circumstances, a partial internal model together with the other components of the standard formula. The risks to be covered by modules of the model include underwriting risk, market risk, credit risk and operational risk. Internal models will need to be used to manage the business and approved by the relevant supervisor. This is likely to require documentation of a high standard which enables the model to be properly understood. Internal models will not, however, be subject to a separate external audit.

ORSA - Article 45 of the Solvency II Directive requires firms to perform a regular ORSA as part of their risk management system. The main purpose of the ORSA is to ensure that a firm engages in the process of assessing all the risks inherent in its business and determines its corresponding capital needs. The ORSA will also allow a firm to determine the adequacy of its regulatory capital position, which requires firms to meet the MCR and SCR at all times.

Own funds - Solvency II includes rules on how insurers’ capital requirements can be satisfied. Capital held is known as 'own funds' and Articles 88 to 90 and 93 to 98 of the Directive prescribe how these are to be determined and classified. Own funds can either be basic own funds (what an insurer has on the balance sheet, for example, the excess of assets over liabilities plus subordinated liabilities) or ancillary own funds (what an insurer may be able to call upon if needed, for example, unpaid capital, letters of credit, guarantees and other legally binding commitments). Ancillary own funds can only be used as capital with the approval of the supervisor. In addition, own funds are divided into three tiers to reflect their permanence and ability to absorb losses. Broadly Tier 1 must have a minimum term of 10 years, Tier 2 of 5 years and Tier 3 of 3 years. This is subject to the very important caveat of the 'sufficient duration principle' which means that the term must reflect the insurer’s underlying liabilities. The MCR cannot be covered by Tier 3 own funds or ancillary own funds. The Framework Directive proposed that at least one third of capital held to cover the SCR needs to be Tier 1 (with the highest level of permanence and loss absorbency) and that no more than one third can be held as Tier 3. However, Level 2 legislation is expected to increase the amount represented by Tier 1 to 50 per cent and reduce the amount represented by Tier 3 to 15 per cent.

Prudent person principle - The current rules on admissible assets (ie, a list of qualifying asset types) will be replaced by the 'prudent person principle' (ie, the requirement to invest so as to ensure the security, quality, liquidity and profitability of the portfolio as a whole) with the requirement that assets covering technical provisions must be invested in 'the best interests' of policyholders. It is not really clear what investment in the best interests of policyholders means but it could cause issues for intra group or strategic investments or where there are potential group conflicts. The prudent person principle effectively places responsibility on the insurer to decide whether the nature of any investment is appropriate and to be able to show that it has appropriate systems and controls to hold and manage any such investments. In practice this may mean insurers having to give their investment managers more detail about the type of investments permitted (particularly where a greater use of derivatives is to be made post Solvency II). Insurers also have to ensure that the location of assets is such as to ensure their availability.

QIS - Both the European Insurance and Occupational Pensions Authority (EIOPA) and its predecessor, the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS), conducted a series of quantitative impact studies (QIS) to gain insight into how the proposals under the Solvency II regime will impact insurers’ balance sheets. The QIS studies are designed to help the European Commission determine the best possible approaches for implementation and to assess the financial impact and practicability of the Level 2 proposals. The last study (QIS5), assessed the practicability, implications and impact of specified approaches to (re)insurers’ valuation of assets and liabilities, as well as capital settings under Solvency II. EIOPA reported that QIS5 revealed that the financial position of the European insurance and reinsurance sector remains sound.

SFCR - The Solvency II Directive includes provisions for more detailed public disclosure of an insurer’s management of its business and capital in the form of a Solvency and Financial Condition Report (SFCR) including a summary written for the benefit of policyholders. In a recent consultation paper, EIOPA consulted on guidelines that specify the public disclosure and supervisory reporting requirements that (re)insurance undertakings will be subject to. The guidelines list EIOPA’s expectations in relation to the content of the narrative SFCR and the Regular Supervisory Report (RSR). The guidelines aim to harmonise public disclosure by specifying the minimum content of certain sections of the reports.

Technical provisions - Technical provisions must correspond to the current amount that the firm would have to pay in order to transfer its insurance and reinsurance obligations immediately to another Solvency II firm. The technical provisions are made up of a best estimate of the probability-weighted average of the future cash flows relating to the insurance and reinsurance obligations of the firm, discounted using a risk-free rate of return, plus a risk margin representing the cost of holding regulatory capital in respect of those insurance and reinsurance obligations.

Third country equivalence assessment - The basic purpose of an equivalence assessment is to ensure that third country regulatory and supervisory regimes provide a similar level of policyholder and beneficiary protection as that provided under Solvency II. There are three different tests under Solvency II. (1) Article 172 relates to reinsurance placed with reinsurers with their head office in the third country concerned. A determination of equivalence will allow reinsurance contracts with these insurers to be treated in the same way as reinsurance contracts with EEA-insurers. (2) Article 227 relates to third country insurers that are part of EEA-groups. A determination of equivalence will allow groups to take into account the local third country calculation of capital requirements and available capital rather than calculating on a Solvency II basis for the purposes of the deduction and aggregation method. (3) Article 260 relates to group supervision of EEA-insurers with parents outside of the EEA. A determination of equivalence will require EEA-supervisors to rely on the group supervision of the third country in question.

Outstanding issues

Transitional arrangements for third country equivalence remain a priority area. It is imperative that proper account is taken of those countries working towards equivalence so that UK and European firms are not put at a competitive disadvantage. EIOPA is in the process of completing third country assessments for transitional equivalence, with the Commission expected to approve the transitional regime sometime in 2014.

There are also other issues that should become clearer once the Level 2 measures are finalised, including the treatment of Expected Profits Included in Future Premiums (EPIFP), Ring-Fenced Funds (RFF) and participations, and the modification of certain SCR modules (including property, structured products and CAT risk).

To help you keep track of any additional developments our blog provides regular updates.

Expected timeline - 2014

The proposed Level 2 text and Level 3 guidelines are subject to the adoption of Omnibus II. The Commission must produce delegated acts containing detailed implementing rules on a wide range of matters including:

  • Calibrations for capital requirements for assets
  • Calculation of the standard formula
  • Principles for evaluating internal models
  • Assessments for third-country equivalence
  • The contents of the ORSA
  • Measures to ensure the system does not overburden small insurers.

An expected timeline has emerged with a ‘near final’ version of the Level 2 delegated acts due in Spring 2014. The Commission is expected to formally adopt the delegated acts in August before the legislative process in the European Parliament and Council of the EU begins. Final agreement is anticipated by February 2015. 

EIOPA has indicated that it will publicly consult on the Level 3 technical standards and guidelines as soon as possible during 2014.

Useful materials

Directives

Solvency II Directive (2009/138/EC)

Omnibus II Directive (proposal)

Final compromise text of Omnibus II resulting from trialogue agreement

First Directive amending the transposition and application dates of the Solvency II Directive

Second Quick Fix Directive amending Solvency II transposition and application dates

EIOPA materials

Guidelines on System of Governance

Guidelines on Forward-looking assessment of the undertaking’s own risks, based on the principles for the Own Risk and Solvency Assessment (ORSA)

Guidelines on Submission of information to National Competent Authorities

Guidelines on Pre-application of internal models

Technical Findings on the Long-Term Guarantees Assessment

Technical report on standard formula design and calibration for certain long-term investments

UK consultation papers

HM Treasury: Consultation on Solvency II

CP11/22 Transposition of Solvency II Part 1

CP12/13 Transposition of Solvency II Part 2

CP11/23 Solvency II and linked long-term insurance business

SS4/13 Solvency II: applying EIOPA’s preparatory guidelines to PRA-authorised firms


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