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Home > Insurance Markets Best Practice > Solvency II—A New Regulatory Framework for the Insurance Sector

Insurance Markets Best Practice

Solvency II—A New Regulatory Framework for the Insurance Sector

by Paul Barrett

Executive Summary

This article examines:

  • The aims of Solvency II.

  • Challenges to the self-regulatory principle.

  • The role of misunderstanding and therefore mispricing risks as one of the key casual factors in creating the crash is now much better understood.

  • The minimum capital requirement proposals in Solvency II continue to be a topic of debate.

  • The role of the “group of 12” in challenging Solvency II has been to delay its implementation.

  • The roadmap to completion.

Introduction

In July 2007, the European Union (EU) introduced the Framework Directive for Solvency II, which aims to be a “modern, risk-based, supervisory framework for the regulation of European insurance and reinsurance companies.”

The aim is for the directive to be enacted into law in member countries by October 2012. In the words of the UK’s Financial Services Authority (FSA), the directive “aims to establish a revised set of EU-wide capital requirements, valuation techniques, and risk management standards” to replace the current Solvency I regime. It will apply to all insurance companies across the EU with a gross premium income exceeding €5 million.

One of the features that those new to the Solvency II directive tend to find confusing is the “three pillars” approach. Pillar One involves insurance companies demonstrating that they have adequate resources to support the business that they are writing. Pillar 2 is about systems of governance, while Pillar 3 focuses on the reporting requirements of the directive, and covers such matters as the firm’s risk management framework and functions, capital add-ons, and supervisory reporting.

The most important feature of Solvency II is its risk-based character: Capital requirements are related to the risk profile of an insurance entity, instead of being set in an arbitrary way on a country-by-country basis by the national regulators and legislators. Higher risks will lead to a higher capital requirement.

A second feature of the Solvency II framework is a greater focus on insurance groups (as opposed to separate legal entities). The existing Solvency I regime, being on a state-by-state basis, finds it impossible to consider groups operating on a pan-European basis, from the perspective of group capital adequacy.

A third feature is the market-consistent valuation for both assets and liabilities. Finally, Solvency II explicitly allows for the use of internal modeling for the calculation of capital requirements.

This very brief summary raises one immediate thought in the light of the current credit crunch. With respect to the banks, we have seen that the Basel II regulatory framework has been rendered rather spectacularly irrelevant, being unable to predict or prevent the banking collapses that have characterized the present credit crunch.

As the Association of British Insurers (ABI) Director General, Stephen Haddrill, said in a recent speech on Solvency II, there are those who now question whether the insurance sector would be better turning away from developing advanced modeling techniques to help the sector run its businesses, as advanced modeling did not help the banks or the banking regulators.

The wisdom of aligning regulatory requirements with management’s own internal targets and priorities, as reflected in an organization’s creation of its own risk-assessment models, is also now being challenged. In a speech made in October 2008, Thomas Huertas, head of banking regulation at the FSA, said: “The broad assumption underlying the Basel capital accord—that regulators around the world could rely on firms’ own risk models as the basis for capital requirements—has not turned out to be correct, at least for the trading book.”

What is now under scrutiny is the application of the self-assessment principle across financial markets, including insurance. The principles that underpinned Basel II were initially similar, and now appear to be moving apart. Basel II, while still not finalized in its amended form, appears to be moving in the direction of more prescriptive regulation. Solvency II, on the other hand is, for the moment, sticking with the idea of firms assessing their own risks and setting capital requirements, then getting regulators to sign off on the assumptions involved. We can expect considerable pressure for Solvency II to move into line with Basel II, which would ensure a consistency of fundamental principles across the sector with respect to setting capital levels for risk-taking financial institutions. However, the impact will almost inevitably be to increase capital reserve requirements.

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