UK: Adapting To The New Regime - Solvency And Stability: The Shifting European Framework For Life Insurers

Last Updated: 11 June 2007
Article by Deloitte Financial Services Group

Most Read Contributor in UK, August 2017

"In continental Europe, some large groups have built economic capital models for capital management purposes. These will need enhancing".

The solvency regime introduced to the UK life insurance market two years ago under ICA rules anticipates some of the changes that the European Union’s Solvency II project to reform prudential regulation of insurance will impose across all 25 member states in 2010 or later. Although this may mean the UK is ahead of its European peers, we anticipate some differences between the regimes which will necessitate reforms by insurers to ensure compliance.

Like the UK system introduced by the Financial Services Authority, Solvency II seeks to increase policyholders’ protection and to support market stability. Advice from the Committee of European Insurers and Occupational Pensions Supervisors (CEIOPS) to the European Commission provides an insight into how it will affect technical provisions, capital structure, risk management and group capital requirements.

We believe the key developments when current UK rules are replaced by the Solvency II regime will be:

  • Unit-linked and non-profit contracts will be fair valued.
  • Technical provisions will include a risk margin.
  • The risk capital calculation will be moved to Pillar One of the new regime and may therefore be disclosed and subject to audit requirements.
  • Diversification effects within insurance groups may be allowed for.

Comparison of regimes

Both regimes are based on a three-pillar approach. The first pillar considers the quantitative requirements of the system, the second pillar deals with the qualitative aspects and the third pillar is concerned with disclosure requirements. The chart over the page provides a comparison:

Technical provisions

Solvency II’s approach towards technical provisions shares many characteristics with the FSA’s approach for the realistic peak. However, as the realistic peak only applies to "realistic reporting firms" holding withprofit funds in excess of £500m, the move to fair values will change the calculation of non-profit and unit linked provisions.

For realistic reporting firms, the main difference is that an explicit risk margin will be added on top of the fair value of future liabilities. This will lead to an increase in the technical provisions that firms need to allow for.

In the fair valuation process the two regimes share the following features:

  • Best estimate assumptions are used to project future cash flows, including lapse assumptions.
  • No surrender floors are to be applied to the value of the technical provisions.
  • Discretionary benefits are to be provisioned for.
  • Cost of options and guarantees are to be valued on a market consistent basis.

Solvency II will move the valuation of nonprofit and unit-linked businesses to realistic reporting. Under the current regime, the valuation of non-profit and UL businesses may still contain arbitrary prudential margins. These will be replaced by the Market Value Margin (MVM). CEIOPS is still debating how the MVM will be calculated.

The surrender value has been used as a floor in the valuation of technical provisions to address the risk of insurers not being able to pay out the surrender benefits, should mass surrenders take place. Under Solvency II, this risk is dealt with more appropriately by capital. We will also see the possibility of considering prudent lapse rates in the calculation of the mathematical reserves.

The FSA have introduced1, from December 2006, changes to the minimum levels of Pillar 1 reserves. They reduce the aforementioned differences between the UK and Solvency II regimes in respect of the non-profits and unit linked businesses. The main changes affecting the non-profits and unit linked businesses are that non-policy related expenses can be reserved within the mathematical reserves rather than at a policy level, policies can be valued as assests if surrender values are not guaranteed and that firms will be allowed to make a prudent lapse rate assumption when calculating the mathematical provisions.

These changes can effectively release some of the current margins embedded in the calculation of mathematical reserves and thus move the calculation of these provisions towards a fair value approach. Some margins will be retained and therefore Solvency II will be replacing these arbitrary margins with a defined calculation. The impact of this will depend on the approach that is finally adopted and the extent of current prudential margins which varies by company.

Minimum Capital Requirement

The UK Minimum Capital Requirement is the higher of the base capital resources requirements and the sum of the long-term insurance capital requirement and the resilience capital requirement.

  • The base capital resources requirement is €2.25m for a Directive mutual, €600,000 for a non-directive mutual and €3m for any other insurer subject to annual indexation based on the European index of consumer prices.
  • The long term insurance capital requirement is the sum of the death risk capital requirement, the health risk capital requirement, the expense risk capital requirement and the market risk capital requirement.
  • The resilience capital requirement is calculated on a series of stress tests that consider the effects of falls in the market value of equities and property and the more onerous of either a fall or rise in yields on all fixed interest securities. PS06/14 removes the resilience capital requirement for realistic reporting firms. CEIOPS is considering three ways of calculating Solvency II’s Minimum Capital Requirements. They are:
  • A calculation based on existing Solvency I requirements; and
  • A simple calculation based on the standard formula of the Solvency Capital Requirement
  • As a margin over liabilities.

An absolute minimum floor expressed in Euros will apply and an allowance for investment risk in the MCR is still to be decided. CEIOPS recommends that during a transitional period of up to three years, the calculation of the MCR is based on a specified percentage of the Solvency I requirements. During the transitional period, Solvency II will likely raise the level of the MCR for an average continental European company. This is unlikely to apply to UK companies as most are well within MCR requirements already. After transition, the MCR will become more risk-oriented.

Solvency Capital Requirement

Pillar 1 and Pillar 2 in the UK currently work independently. Whilst Pillar 1 calculations form part of returns provided to the supervisor and are available to the public, Pillar 2 calculations are available exclusively to the regulator. Under Solvency II, the riskbased capital will be calculated in Pillar 1 and will be in the public domain. This may well lead to audit requirements with respect to risk capital calculations and processes. Insurers would face the significant challenge of increasing the quality and documentation of their models and processes.

The UK’s twin peak approach was introduced to complement existing Solvency I requirements. With the move of the riskbased capital calculation to Pillar 1 under Solvency II, there will no longer be a need for a twin peak calculation followed by an additional calculation in Pillar 2.

In continental Europe, some large groups have built economic capital models for capital management purposes. These will need enhancing. Some medium and small firms still need to embrace the risk-based capital concept and develop their models and knowledge. Their biggest challenge will be developing a risk management framework capable of withstanding the new supervisory review process.

CEIOPS’ working hypothesis is that the SCR will be calibrated consistent with a 99.5% confidence level over a one-year timeframe – the level used in the UK. However, firms will be required to have sufficient capital at a chosen confidence level to be able to survive a year and then, at the year-end, hold sufficient reserves so their liabilities could be transferred to a third party, ensuring an orderly run off.

This differs from the UK, where the Individual Capital Assessment (ICA) is determined on the assumption that assets held at the year-end need to be merely sufficient to cover best estimates of liabilities at the chosen confidence level.

In its second Quantitative Impact Study (QIS2) in May, CEIOPS attempted to calibrate the standard formula at a 99.5% confidence level, suggesting stress tests in some cases. We anticipate that a comparison between the stress tests companies use within their internal model calculations and those proposed within the standard formula approach will be inevitable. Companies will need to justify any large differences. This may thrust an additional task upon many UK firms. Our latest ICA survey2 suggests that, for example, there may be a significant gap between the assurance mortality trend stress levels currently being applied in the UK and those CEIOPS is suggesting.

Capital structure

Solvency capital’s main purpose is to protect policyholders against unexpected losses. Therefore, capital requirements are determined by their ability to absorb losses not only on an ongoing basis but in financially-stressed conditions. Under Solvency II, three tiers of capital are proposed. Tier 1 is composed of the highest quality capital.

Tier 2 consists of capital that, despite lacking some of the characteristics of Tier 1, still provides some degree of loss absorbency. Tier 3 considers elements that are subject to regulatory approval. A similar concept is used under the UK solvency framework where capital is divided into two tiers.

Risk management improvement

Although capital acts as a buffer should unforeseeable risks materialise and provides some protection that policyholders’ benefits will be met as they fall due, regulators are increasingly seeking to stimulate corporate structures and risk management frameworks as a key factor of solvency. Both the UK and Solvency II regimes seek to do this.

Under Solvency II, company boards will be responsible for setting risk tolerance limits, with senior management responsible for implementing risk management strategies. Firms will need to establish a risk management function in charge of monitoring, controlling and reporting compliance. In the UK, the FSA also asks firms to demonstrate that the ICA is embedded into their business. The FSA’s view is that the integration of risk and capital management is on the agenda of several firms but only limited progress has been made to date.

Insurance groups

The UK group capital resources requirement is calculated as the sum of the individual capital resources requirement of the parent company and the individual capital resources requirement of each of its regulated related undertakings3.

The calculation under Solvency II is likely to allow for diversification effects, provided that concerns about the assessment and evidence of the existence of such effects are addressed4. The group capital requirement could therefore be lower than the sum of the solo solvency capital requirements of its component entities. CEIOPS also suggests that the diversification effects could be passed down to individual entities of the group by notionally increasing the available capital, rather than decreasing the capital requirements.

Solvency II can be regarded as the natural progression of a process that has already started in the UK and should mean that UK insurers are further along in the process than their European counterparts. However, UK insurers need to enhance and adapt many processes involved in assessing and managing risks. Particular attention needs to be given to fully embedding the new framework into the day-to-day running of insurance businesses. There are also specific technical points to be addressed such as scenario testing and the assessment of operational risk, which still remain sketchy5.

Footnotes

  1. PSO6/14 was published in December 2006.
  2. Individual Capital Assessment Survey carried out by Deloitte & Touche LLP in March 2006
  3. See the Integrated Prudential Sourcebook PRU 8.3.33 R
  4. See CEIOPS Consultation Paper 14 "Draft Advice to the European Commission in the framework of the Solvency II project on sub-group supervision, diversification effects, cooperation with third countries and issues related to the MCR and SCR in a group context"
  5. See FSA’s comments on Operational risk in their Insurance Sector Briefing: ICAS – one year on

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.