The following ten things are important features of the new prudential supervisory regime for insurance companies which will take effect in the European Union at the beginning of 2016.
1. Risk-based capital
Solvency II is a risk-based capital regime, similar in concept to Basel II, based on three "pillars". Pillar 1 is a market consistent calculation of insurance liabilities and risk-based calculation of capital. Pillar 2 is a supervisory review process. Pillar 3 imposes reporting and transparency requirements.
Solvency II will apply to most insurers and reinsurers with their head office in the European Union (EU), including mutuals, and companies in run-off unless their annual premium income is less than €5 million. The directive should however be applied in a way which is proportionate to the nature, scale and complexity of the insurer. Solvency II will replace existing life and non-life directives, the reinsurance directive and various other insurance-related directives (but not the insurance mediation directive).
Solvency II will be implemented for insurers on 1 January 2016. Much of the detail is contained in the Level 2 Regulation which is directly applicable in Member States. The European Insurance and Occupational Pensions Authority (EIOPA) has finalised Set 1 of the Level 3 Guidelines and is still consulting on Set 2. The regime includes transitional arrangements in a number of areas including the calculation of Solvency Capital Requirements and some grandfathering (e.g. of existing capital instruments).
4. Capital calculation
The calculation of insurance liabilities under Solvency II, known as technical provisions, includes a 'best estimate' of liabilities and a risk margin (where the liability is not appropriately hedged). Capital is known as ‘Own Funds’ and is divided into 3 Tiers (1-3) reflecting permanence and the ability to absorb losses. The risk based capital requirement, the Solvency Capital Requirement (SCR), will be calculated using either a standard formula; a bespoke internal model that has been approved by the insurer’s supervisor; or a mixture of both. The standard formula will cover underwriting risk, market risk, credit risk and operational risk in a formulaic way (e.g. assumed stress level for equities). The calculation will be calibrated to seek to ensure a 99.5 per cent confidence level over a 1 year period which is said to equate to a BBB rating. There is also a Minimum Capital requirement (MCR) set at lower threshold (e.g. about 85 per cent confidence level). The MCR should not be less than 25 per cent of the SCR. Breach of the MCR is designed, unless remedied quickly, to lead to a loss of the insurer’s authorisation. Breach of the SCR results in supervisory intervention designed to restore the SCR level of capital.
The detailed rules requiring investment of assets in a list of specified ‘admissible assets’ and the counterparty and asset limits contained in the current regime for EU insurers will be replaced by the 'Prudent Person Principle'. This will place greater responsibility for investment decisions on the insurer (and there will be significantly increased reporting requirements in relation to assets). The insurer’s capital should then reflect its asset position resulting in a need to match assets to liabilities as closely as possible. For UK linked contracts, the permitted links rules (amended in places to make them no more onerous than the rules applicable to UCITS) will also apply where the policyholder is a natural person.
There will also be a group SCR requirement - normally calculated on a consolidated basis. This can reflect diversification benefits but has the downside for EU headed groups of requiring them to calculate the solvency of non-EU subsidiaries on a Solvency II basis. It may, with supervisory approval, be possible to calculate non-EU subsidiaries’ solvency positions using local rules - if the relevant jurisdiction is 'equivalent' under Solvency II rules, although this will then preclude taking any benefit for diversification with that entity. EIOPA has concluded that Switzerland meets the equivalence criteria for these purposes. Bermuda has been deemed ‘equivalent’ for non-life business and ‘partly equivalent’ for life business. Groups that are headquartered outside the EEA will nevertheless be subject to European group supervision unless another regulator is exercising equivalent group supervision. Again, Switzerland and Bermuda have been assessed by EIOPA as broadly equivalent. The European Commission will take the final decision of equivalence. Solvency II also provides for ‘temporary’ and ‘provisional’ equivalence regimes. Temporary equivalence will be available to third countries with a Solvency II type solvency model in relation to group supervision and reinsurance activities, subject to certain conditions. Non-EU headed groups with EU subsidiaries may be deemed ‘provisionally equivalent’ in relation to group SCR calculations if they are based in third countries with a solvency regime that is capable of being equivalent.
7. Risk mitigation
Solvency II insurers will need to comply with rules relating to risk mitigation techniques and reinsurance. For non-EU based reinsurers, if they are not rated as at least BBB and do not collateralise the reinsurance, they will need to be based in countries which meet the requirement of 'equivalence' for the cedant to be able to take credit for the reinsurance. EIOPA has assessed Bermuda, Switzerland and Japan as equivalent for the purposes of reinsurance.
Solvency II imposes formal governance requirements, mandating roles such as a risk management function, an independent audit function, an actuarial function and a compliance function. The insurer's processes for risk management should be set out in an Own Risk and Solvency Assessment (ORSA). The ORSA should include a risk-based assessment of the insurer’s solvency needs based on its business and its own risk appetite and must be taken into account in running the business. The relevant supervisor will review this as part of the Pillar 2 process. Solvency II also imposes requirements in relation to outsourcing and remuneration.
Pillar 3 requirements under Solvency II will be a mixture of EU mandated requirements and PRA requirements. They will include a private Regular Supervisory Report (or "Report to Supervisors") to be provided on a regular basis appropriate to the nature and size of the insurer. There will also be a public annual report called the Solvency and Financial Condition Report (SFCR) which will include both narrative and numbers (in a specified format). It is expected that the calculation of technical provisions in the UK will be subject to an audit requirement.
The role of the insurance supervisor is very important and the success or otherwise of Solvency II will, to a large extent, be dependent on its implementation by insurance supervisors in a consistent manner. EIOPA Guidelines cover the detailed areas where there could be a divergence of practice. The directive also contains provisions relating to establishment and operation of the college of supervisors. It is intended that in group situations the relevant supervisors, led by the group supervisor, will co-operate and act in a co-ordinated manner.