UK: Solvency II – Be Prepared, Be Very Prepared

Last Updated: 15 March 2010
Article by Natasha Lee

31 October 2012 may seem a long way off, but for insurance firms the clock is ticking and 2010 represents a key year of preparation.

Solvency II was adopted on 5 May 2009 and will 'go live' on 31 October 2012, replacing Solvency I. It will apply to all insurance and reinsurance firms with gross premium income greater than €5m, or gross technical provisions greater than €25m.

The aim of Solvency II is to develop a single market for insurance services in Europe without any detrimental impact on consumers. Solvency II will be based on economic principles for the measurement of assets and liabilities. In support of this, it will also look to use enterprise risk management principles, regulating firms according to their inherent business risks; firms will be required to assess their own risk profile, ensuring they have sufficient capital and governance, and risk management processes to manage such risks.

Solvency I is no longer deemed to be suitable due to the belief that current regulatory requirements can lead to material differences between regulatory capital and economic capital required to run the insurance business.

Pillars

Commonly known as 'Basel for insurers', Solvency II is similar to Basel II, which governs the regulation of banks, building societies and investment firms. The best example of this comes via the Solvency II framework, which is also based on a three-pillar approach.

Pillar 1 – Quantitative Requirements

Pillar 1 applies to all firms and considers quantitative requirements, including own funds, technical provisions and calculation of the Solvency II capital requirement (the solvency capital requirement (SCR) and minimum capital requirement (MCR)), through either an approved full or partial internal model or the European standard formula approach.

Pillar 2 – Firm Assessment And Supervisor Review

Pillar 2 requires an additional capital assessment by placing the emphasis on firms to conduct an internal assessment of its inherent business risks and internal controls, referred to as the own risk and solvency assessment (ORSA), which is subject to supervisory review and approval.

Pillar 3 – Public Disclosure And Regulatory Reporting Requirements

The requirements to disclose information relating to risk and capital levels, designed to help exert discipline of market influence. Pillars 2 and 3 combined are now referred to as Pillar 5.

Pillar 1 represents the quantitative element of Solvency II, whereas Pillar 5 is more qualitative in nature, given its reporting, disclosure and risk management requirements.

Solvency II is being led by the European Union (EU), which is adopting a procedure known as the Lamfalussy approach. This splits the regulatory framework into four levels.

Level 1: directives setting out a framework of principles.

Level 2: measures implementing the principles in the Level 1 directive. The European Commission (EC) develops these measures with technical input from the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) and adopts them following consultation with member states through the European Insurance and Occupational Pensions Committee of representatives from Finance Ministries (EIOPC).

Level 3: CEIOPS produces joint recommendations and consistent guidelines and measures. These may include guidance for national regulators to ensure consistent interpretation of the Level 1 directive and Level 2 measures.

Level 4: enforcement by the EC to ensure effective and consistent implementation of EU legislation.

Implementation

Many insurance firms will have to make fundamental changes within their business, while at the same time continuing to run existing business operations. All of which will require time, resource and finance.

Detailed below are some key areas insurance firms may wish to consider, if they have not already done so, as part of the implementation process.

Gap Analysis

In essence, before an insurance firm commences any significant implementation work, it first needs to identify which 'gaps' need filling. A firm needs to identify its implementation date and then work backwards by plotting its current position, thereby identifying the gaps that need to be filled. Once the gaps have been identified, an overall implementation plan can be formulated in respect of how and when the gaps are to be filled.

Internal Models

Many firms will want to adopt their own internal model for calculating capital requirements under Pillar 1. As at November 2009, approximately 100 insurance firms had already indicated to the FSA that they would like to take this approach.

If they do wish to take this approach it is crucial that they communicate with the FSA immediately, expressing their intentions, as well as their expected timeline for developing the model and submitting their application for approval. The FSA has already indicated that it will need six months to review completed applications. Furthermore, due to its own resource constraints, the FSA has introduced a pre-application approval process requiring insurance firms to demonstrate their commitment to adopting an internal model before they are even allowed to submit their application.

In light of this, and in the context of each insurance firm's resources and timeline, firms should ensure they have a back-up plan for 2012 implementation, that being either the standard formula under Pillar 1 or a partial internal model.

Group Supervision

The directive does not include the 'group support' regime, whereby subsidiaries meet their MCR using locally held capital but rely on a parental guarantee to meet their SCR, although this is expected to be reviewed three years post implementation of Solvency II.

However, lead supervisors will still be required to review the group SCR calculation and specify capital add-ons where necessary, in consultation with local regulators.

Culture

A key consequence for insurance firms will be the impact on culture. Solvency II will require firms to understand their inherent risks and how best to manage those risks. In particular, the board will need to demonstrate its awareness of such factors and lead from the front – delegation of tasks will be permitted, but not overall responsibility and awareness.

Resourcing

One key criterion insurance firms must assess early on will be their own resourcing requirements, both for implementation and on-going requirements. This will encompass not only personnel but may also include systems and processes, financial investment and professional advisers.

There is no hard and fast rule for implementation and every insurance firm is different, both in terms of its resources and related requirements. However, one rule is applicable to all insurance firms: preparation is fundamental. So the earlier firms start, the easier implementation of Solvency II will become. In particular, as the implementation date approaches, resources will become more scarce – so firms beware, as you could be found wanting.

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.

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