EU Directive 2009/138/EC, known as 'Solvency II', introduces a harmonised, risk-based solvency regime in the EU insurance market and aims to implement improved capital adequacy requirements and risk management standards from 31st December 2012. The Directive's main objective is ensuring greater policyholder protection through improved risk awareness in governance and operations. It imposes a supervisory system that is consistent throughout the EU through which it also aims to integrate the European insurance market and increase competitiveness among insurers.
The three pillars
Solvency II sets out a framework with the rules divided into three "pillars" as follows;
Pillar 1: quantitative requirements
The first pillar defines the capital resources that an insurance company needs in order to absorb unforeseen losses so that the financial stability of the company is secured. It establishes how to calculate the Solvency Capital Requirement ('SCR') using either a standard formula or a regulator-approved internal model. If the SCR is breached, the situation must be rectified within six months and "significant" breaches of the SCR must be publicly reported. In addition to the SCR, a Minimum Capital Requirement ('MCR') is the minimum level of solvency that insurers and reinsurers are required to maintain. The MCR cannot fall below 25% or exceed 45% of the SCR or policyholders will be exposed to unacceptable risk. Any breach of the MCR will automatically trigger serious supervisory action. This pillar also refers to technical provisions, the reserves that an insurance company is required to hold against its liabilities to policyholders and beneficiaries.
Pillar 2: governance & supervision
The second pillar focuses on the implementation of effective risk management systems within insurance companies throughout the EU market. It will be necessary to identify, measure and manage risks proactively, and to ensure that appropriate financial resources are maintained against these risks. Companies will be required to establish specific areas of responsibility for risk management, compliance, internal audit and actuarial issues. Insurance companies will also be required to undertake an internal review (known as "Own Risk and Solvency Assessment" ('ORSA')) annually of their governance systems and their capital needs which will be in turn subject to external review.
Pillar 3: disclosure & transparency
The third pillar focuses on disclosure – insurers will be required to publish details of the risks facing their companies to create increased market transparency. Insurers should provide key, verifiable information relevant to their capital adequacy. The aim of this pillar is to provide transparency to impose greater discipline and stability in the industry.
The effect of Solvency II
One of the direct effects of Solvency II on insurance companies is that senior executives will be expected to fully understand the implications of the directive and accordingly improve their management of capital and risk analysis. A robust and transparent corporate governance structure will need to be implemented within the organisation in order to effectively manage risk and ensure regulatory compliance. Should a company fail to satisfy a regulator that its systems, controls and governance procedures are not effective, an additional capital charge may be applied. Accordingly, companies will need to prepare their organisations for substantial changes in their strategy, processes, management and governance of their business.
It is also imperative that companies invest in employees that have the appropriate expertise and knowledge to operate the new systems and analyse the risk exposure effectively. More particularly, there will be an increased need for actuarial, compliance, IT and risk management personnel. Companies should examine their recruitment needs and invest in training for existing employees as soon as possible to ensure that such resources are available in advance of December 2012. Recruitment firms are already experiencing a high demand for candidates with the necessary skills as a result of Solvency II. In addition, companies should arrange for all members of staff to be fully informed on the implications of the Directive and its effects on the organisation. An understanding of the changes that will take place internally throughout the organisation at every level and in every department will make the transition a far smoother one.
Comment
There is no doubt that making a company Solvency II compliant will be costly. Insurance companies will need more capital to run their business which is likely to lead to a significant number of insurers restructuring and consolidating their businesses, as seen with Aviva's recent merging of its twelve UK general insurance companies. Niche insurance companies may need to consider consolidating with competitors or merge with bigger market players in order to remain competitive. The administrative costs of an organisation complying with Solvency II are also not to be underestimated. At the FSA Solvency II Conference on 18 April 2011, Hector Sants (Chief Executive of the FSA) discussed the effect of Solvency II. Whilst he noted that the costs of implementation initially may outweigh the benefits of Solvency II for smaller insurance companies given that larger companies are able to diversify risk across their larger portfolios of business, he submitted that in the long term, all companies would benefit from the harmonised regime. Sants identified three key benefits of Solvency II as follows:
- greater policyholder protection;
- the creation of a harmonised regime across Europe which will make it easier for firms to operate within the EU on a cross border basis; and
- the raising of standards in non-EU countries as they will seek equivalence.
Whether or not Solvency II will achieve such results, remains to be seen.
Lessons can be learned from Basel II, the equivalent regime in the banking sector. Insurance companies should prepare well in advance of 31 December 2012 and begin developing and implementing the internal risk systems and governance structures as soon as possible so that the Solvency II directive may be used to their advantage competitively rather than become a compliance headache.
The contents of this article are intended as guidelines for clients and other readers. It is not a substitute for considered advice on specific issues. Consequently, we cannot accept any responsibility for this information or for any errors or omissions.
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