Solvency II: Restructuring the Insurance Sector (Part 2)

The Solvency Act is going to have major ramifications for the Insurance sector in the European Union in particular, and is being watched keenly by governments of other nations. In part 1, we had a brief look at the directives that this directive is looking at amending. The Solvency Directive is an impending measure to manage risk, protect rights of claimants and prevent any major loss in the vent of systemic failure. This directive aims at being an early intervention measure by implementing the Minimum Capital requirements by Insurance companies. We will also discuss the Solvency Capital requirement to be implemented in the event the supervisor finds the company in an almost miss situation.

Supervisors are expected to assess risk in proportion to the nature, scale and complexity of the risks inherent in the business of an insurance or reinsurance undertaking, regardless of the importance of the undertaking for the overall financial stability of the market. Supervisors are expected to carry out regular reviews and evaluations. Supervisory authorities should be able to take account of the effects on risk and asset management of voluntary codes of conduct and transparency complied with by the relevant institutions dealing in unregulated or alternative investment instruments.

Solvency Capital Requirement: The starting point for the adequacy of the quantitative requirements in the insurance sector is the Solvency Capital Requirement. Supervisory authorities should therefore have the power to impose a capital add-on to the Solvency Capital Requirement only under exceptional circumstances The Solvency Capital Requirement standard formula is intended to reflect the risk profile of most insurance and reinsurance undertakings. However, there may be some cases where the standardized approach does not adequately reflect the very specific risk profile of an undertaking.

Capital Add-on: The capital add-on should be retained for as long as the circumstances under which it was imposed are not remedied. In the event of significant deficiencies in the full or partial internal model or significant governance failures the supervisory authorities should ensure that the undertaking concerned makes every effort to remedy the deficiencies that led to the imposition of the capital add-on. However, where the standardised approach does not adequately reflect the very specific risk profile of an undertaking the capital add-on may remain over consecutive years.

Internal Model: All insurance and reinsurance undertakings should have, as an integrated part of their business strategy, a regular practice of assessing their overall solvency needs with a view to their specific risk profile (own-risk and solvency assessment). That assessment neither requires the development of an internal model nor serves to calculate a capital requirement different from the Solvency Capital Requirement or the Minimum Capital Requirement. The results of each assessment should be reported to the supervisory authority as part of the information to be provided for supervisory purposes.

Public Disclosures: To guarantee transparency, insurance and reinsurance undertakings should publicly disclose – that is to say make it available to the public either in printed or electronic form free of charge – at least annually, essential information on their solvency and financial condition. Undertakings should be allowed to disclose publicly additional information on a voluntary basis.

Assessment and Valuation: Valuation standards for supervisory purposes should be compatible with international accounting developments, to the extent possible, so as to limit the administrative burden on insurance or reinsurance undertakings.

Capital Requirements: In accordance with that approach, capital requirements should be covered by own funds, irrespective of whether they are on or off the balance-sheet items. Since not all financial resources provide full absorption of losses in the case of winding-up and on a going-concern basis, own-fund items should be classified in accordance with quality criteria into three tiers, and the eligible amount of own funds to cover capital requirements should be limited accordingly. The limits applicable to own-fund items should only apply to determine the solvency standing of insurance and reinsurance undertakings, and should not further restrict the freedom of those undertakings with respect to their internal capital management. Assets which are free from any foreseeable liabilities are available to absorb losses due to adverse business fluctuations on a going-concern basis and in the case of winding-up. Therefore the vast majority of the excess of assets over liabilities, as valued in accordance with the principles set out in this Directive, should be treated as high-quality capital (Tier 1).

Ring Fence: Not all assets within an undertaking are unrestricted. In some Member States, specific products result in ring-fenced fund structures, which give one class of policy holders greater rights to assets within their own fund. Although those assets are included in computing the excess of assets over liabilities for own-fund purposes they cannot in fact be made available to meet the risks outside the ring-fenced fund. To be consistent with the economic approach, the assessment of own funds needs to be adjusted to reflect the different nature of assets, which form part of a ring-fenced arrangement. Similarly, the Solvency Capital Requirement calculation should reflect the reduction in pooling or diversification related to those ring-fenced funds.

Measure Risk Sensitivity: The supervisory regime should provide for a risk-sensitive requirement, which is based on a prospective calculation to ensure accurate and timely intervention by supervisory authorities (the Solvency Capital Requirement), and a minimum level of security below which the amount of financial resources should not fall (the Minimum Capital Requirement). Both capital requirements should be harmonised throughout the Community in order to achieve a uniform level of protection for policy holders. For the good functioning of this Directive, there should be an adequate ladder of intervention between the Solvency Capital Requirement and the Minimum Capital Requirement.

Avoiding Systemic Failure: In order to mitigate undue potential pro-cyclical effects of the financial system and avoid a situation in which insurance and reinsurance undertakings are unduly forced to raise additional capital or sell their investments as a result of unsustained adverse movements in financial markets, the market risk module of the standard formula for the Solvency Capital Requirement will include a symmetric adjustment mechanism with respect to changes in the level of equity prices. In addition, in the event of exceptional falls in financial markets, and where that symmetric adjustment mechanism is not sufficient to enable insurance and reinsurance undertakings to fulfill their Solvency Capital Requirement, provision will be made to allow supervisory authorities to extend the period within which insurance and reinsurance undertakings are required to re-establish the level of eligible own funds covering the Solvency Capital Requirement.

The Solvency Capital Requirement should reflect a level of eligible own funds that enables insurance and reinsurance undertakings to absorb significant losses and that gives reasonable assurance to policy holders and beneficiaries that payments will be made as they fall due. In order to ensure that insurance and reinsurance undertakings hold eligible own funds that cover the Solvency Capital Requirement on an on-going basis, taking into account any changes in their risk profile, those undertakings should calculate the Solvency Capital Requirement at least annually, monitor it continuously and recalculate it whenever the risk profile alters significantly.

The Solvency Act aims to promote good risk management and align regulatory capital requirements with industry practices. The Solvency Capital Requirement should be determined as the economic capital to be held by insurance and reinsurance undertakings in order to ensure that ruin occurs no more often than once in every 200 cases. These undertakings should still be in a position, with a probability of at least 99,5 %, to meet their obligations to policyholders and beneficiaries over the following 12 months. That economic capital should be calculated on the basis of the true risk profile of those undertakings, taking account of the impact of possible risk-mitigation techniques, as well as diversification effects