Solvency II

1. Background information

Solvency II is a fundamental review of the capital adequacy regime for the European insurance industry. It aims to establish a revised set of EU-wide capital requirements and risk management standards that will replace the current Solvency 1 requirements.

Central elements of the Solvency II regime include:

1. Demonstrating adequate Financial Resources (Pillar 1): applies to all firms and considers key quantitative requirements, including own funds, technical provisions and calculation of the Solvency II capital requirements (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.
2. Demonstrating an adequate System of Governance (Pillar 2): including effective risk management system and prospective risk identification through the Own Risk and Solvency Assessment (ORSA).
3. Supervisory Review Process: the overall process conducted by the supervisory authority in reviewing insurance and reinsurance undertakings, ensuring compliance with the Directive requirements and identifying those with financial and / or organizational weaknesses susceptible to producing higher risks to policyholders.
4. Public Disclosure and Regulatory Reporting Requirements (Pillar 3).

Solvency II is being created in accordance with the Lamfalussy four-level process:

Level 1: framework principles - this involves developing a European legislative instrument that sets out essential framework principles, including implementing powers for detailed measures at Level 2

Level 2: implementing measures - this involves developing more detailed implementing measures (prepared by the Commission following advice from CEIOPS) that are needed to operationalise the Level 1 framework legislation

Level 3: guidance - CEIOPS works on joint interpretation recommendations, consistent guidelines and common standards. Additionally, CEIOPS undertakes peer reviews and compares regulatory practice to ensure consistent implementation and application.

Level 4: enforcement - more vigorous enforcement action by the Commission is underpinned by enhanced cooperation between member states, regulators and the private sector.
FSA: Solvency 2

Solvency II draft framework
FAQ
Groupe Consultatif
Solvency II glossary
European commission's solvency II index page
Solvency II expert news
Discussion paper uk
feedback
FSA on Solvency II
EMB (Brochure 1)
EMB (Brochure 2)
PWC: Solvency 1
PWC: Solvency 2
PWC: Solvency 3

2. Definitions

The proposed framework of Pillar 1:

The first level will be a best estimate of liabilities, which will then be augmented by a risk margin to reflect any uncertainty in the future cash flows. In the absence of a liquid market in insurance liabilities, the risk margin is likely to be based on a proxy "cost-of-capital". This will reflect the return on the capital a nominal buyer would need to support the liabilities acquired from the holder over the whole run-off period. The next level will be the "safety floor" of a minimum capital requirement (MCR). Any drop below the MCR will lead to supervisory intervention. Finally, there will be a "risk-sensitive" solvency capital requirement (SCR) that is set to include an evaluation of operational risk, along with insurance, investment and other financial risks. The proposed SCR will be based on a 99.5% confidence level of remaining solvent in the next 12 months, along the lines of the UK's Individual Capital Adequacy Standards (ICAS).

Insurers can opt for a "standardized" approach that uses a set, albeit complex, formula to calculate the SCR. Companies with more sophisticated modelling systems can seek to qualify for an "advanced" approach in which the SCR will equate to their own evaluations of their risk profile and associated capital needs. This "advanced" approach would be subject to supervisory approval.
PWC: Countdown To Solvency II (PDF)

Solvency II will use a market-consistent "economic" approach to the valuation of assets and liabilities. Assets will be fair valued (mark-to-market). The technical provisions will be based on their "current exit value" (market transfer price). To achieve this, the technical provisions will be broken down into those that can be hedged (mark-to-market valuation) and those that cannot (discounted best estimate, plus a risk margin using a cost-of-capital approach). The Solvency II technical provision valuation rules are conceptually in line with the latest proposals for a revised IFRS for insurance contracts (IFRS Phase II), though it is important to note that Solvency II would apply more widely than IFRS.
PWC: Gearing Up To Solvency II (PDF)

Assets and liabilities:

Member States shall ensure that, unless otherwise stated, insurance and reinsurance undertakings value assets and liabilities as follows:
a)assets shall be valued at the amount for which they could be exchanged between knowledgeable willing parties in an arm's length transaction;
b)liabilities shall be valued at the amount for which they could be transferred, or settled, between knowledgeable willing parties in an arm's length transaction.

(Article 74(1), Draft Framework Directive)

Technical Provisions:

The value of technical provisions shall correspond to the current amount insurance and reinsurance undertakings would have to pay if they were to transfer their insurance and reinsurance obligations immediately to another insurance or reinsurance undertaking.

(Article 75(2), Draft Framework Directive)

The value of technical provisions shall be equal to the sum of a best estimate and a risk margin as set out in paragraphs 2 and 3.

(Article 76(1), Draft Framework Directive)

The best estimate shall correspond to the probability-weighted average of future cash-flows, taking account of the time value of money (expected present value of future cash-flows), using the relevant risk-free interest rate term structure.

The calculation of the best estimate shall be based upon up-to-date and credible information and realistic assumptions and be performed using adequate, applicable and relevant actuarial and statistical methods.

The cash-flow projection used in the calculation of the best estimate shall take account of all the cash in- and out-flows required to settle the insurance and reinsurance obligations over the lifetime thereof.

The best estimate shall be calculated gross, without deduction of the amounts recoverable from reinsurance contracts and special purpose vehicles. Those amounts shall be calculated separately, in accordance with Article 80.

(Article 76(2), Draft Framework Directive)

Risk margin:

The risk margin shall be such as to ensure that the value of the technical provisions is equivalent to the amount insurance and reinsurance undertakings would be expected to require in order to take over and meet the insurance and reinsurance obligations.

(Article 76(3), Draft Framework Directive)

Insurance and reinsurance undertakings shall value the best estimate and the risk margin separately. However, where future cash flows associated with insurance or reinsurance obligations can be replicated reliably using financial instruments for which a reliable market value is observable, the value of technical provisions associated with those future cash flows shall be determined on the basis of the market value of those financial instruments. In this case, separate calculations of the best estimate and the risk margin shall not be required.

(Article 76(4), Draft Framework Directive)

Where insurance and reinsurance undertakings value the best estimate and the risk margin separately, the risk margin shall be calculated by determining the cost of providing an amount of eligible own funds equal to the Solvency Capital Requirement necessary to support the insurance and reinsurance obligations over the lifetime thereof.

The rate used in the determination of the cost of providing that amount of eligible own funds (Cost-of-Capital rate) shall be the same for all insurance and reinsurance undertakings and shall be reviewed periodically.

The Cost-of-Capital rate used shall be equal to the additional rate, above the relevant risk-free interest rate, that an insurance or reinsurance undertaking would incur holding an amount of eligible own funds, as set out in Section 3, equal to the Solvency Capital Requirement necessary to support the insurance and reinsurance obligation over the lifetime of that obligation.

(Article 76(5), Draft Framework Directive)

Time value:

For Solvency II, the discount rate in Article 76(2) of the draft Framework Directive is to be based on "the relevant risk-free interest rate term structure". In practice swap yields have been used for all the quantitative impact studies to date.