Legislation

Solvency II - objectives
 Increase level of harmonization of solvency regulation across Europe (leading to greater competition)
 Protect PHs
 Introduce K requirements that are more sensitive (than Solvency I requirements) to levels of risk
 Provide appropriate incentives for good RM.
 EIOPA
European Insurance & Occupational Pensions Authority, one of EU’s main financial supervisory bodies.

 Provided technical advice and support to the European Commission

 Development of the delegated acts
 Responsible for producing some technical standards & additional guidance.
Transitional arrangements
 Transitional arrangements are available for some aspects (e.g. technical provisions, risk-free interest
rates, continued use of ICA), for a defined period (up to 16 years).

 Intention is to avoid unnecessary disruption of markets and availability of insurance products.

 However, UK firms have had to make a formal application to the PRA to be permitted to use the
transitional arrangements.
Framework – 3 pillars

• Quantitative • Qualitative & • Reporting,

Pillar 1

Pillar 3
Pillar 2
requirements supervisory disclosure and
requirements market
• Balance discipline
sheet • Governance
• MCR • ORSA • SFCR and RSR
• SCR • Supervisory • Disclosure
review • Transparency
Pillar 1: Quantitative
 Specifies valuation methodologies for A’s & L’s (technical provisions), based on mkt consistent principles

 Under Pillar 1 there are two distinct K requirements: MCR and SCR

 SCR can be calculated using a prescribed standard formula approach, or by using a company-specific
internal model, which has to be approved by the regulator.

 SCR & MCR both represent K requirements that must be held in addition to the technical provisions.

 Supervisors may decide that a firm should hold additional K (as a capital add on) against risks that are
either not covered or are not adequately modelled for SCR.
Pillar 2: Qualitative and Review
 Supervisory review process, systems of governance & RM

 Under Pillar 2 each insurer is required to carry out an Own Risk & Solvency Assessment (ORSA).

 The ORSA requires each insurer to:

 identify risks to which it is exposed including those not covered under Pillar 1
 identify the RM processes and controls in place
 quantify its ongoing ability to continue to meet the MCR and SCR.
Pillar 3: Reporting and disclosure
 Pillar 3 is disclosure and supervisory reporting regime, under which defined reports to regulators
and the public are required to be made.

 Prescribed disclosures to supervisors, policyholders and investors

Overall
 Minimum capital standards
 Qualitative RM requirements
 Well defined and rigorous review process of companies solvency
 Prescribed disclosure to supervisors, PHs and investors
Pillar 2 - Requirement
 Board has overall responsibility for ongoing compliance with Solvency II.

 All insurers are required to have a:

 RM function
 Actuarial function
 Compliance function
 Internal audit function.

 Each key function should have clear segregation of responsibilities

Pillar 2 - ORSA
 In addition to MCR and SCR, need to have ORSA
 “The entirety of processes and procedures employed to identify, assess, monitor, manage and report
the short and long-term risks an insurer faces to determine funds required for solvency at all times.
 ORSA used by senior management to make decisions
 Firm should be able to demonstrate its use.
Pillar 3 – Supervisory Reporting
 Results of solvency calculation and details of the ORSA and RM processes
 Need to be disclosed privately to the supervisor in the Regular Supervisory Report (RSR),
 It includes both Qualitative information and Quantitative Reporting Templates (QRT).

 RSR, including QRT, must be submitted annually.

 A subset of the QRT (to support the MCR calculation) is required quarterly.
Pillar 3 – Annual QRT
 Balance sheet
 Premiums, claims and expenses by line of business
 Own funds
 K requirements (SCR and MCR)
 Assets
 Collective investment undertakings
 Derivatives
 Technical provisions
 Group reporting
 Reinsurance undertakings.
Pillar 3 – Public disclosure
 Public SFCR (annually produced) can be disclosed in public
 Extracts from QRT
 Some of the qualitative information from the RSR

 SFCR must be published, and a copy provided to the PRA, within 3-4 months of a firm’s year-end.
Group reporting requirements
 Solvency II aims to enable insurance groups to be supervised more efficiently through a “group
supervisor” in the home country, co-operating with other relevant national supervisors.

 This ensures
 Group-wide risks are not overlooked
 Groups operate more effectively
 Provide PH protection.

 It also aims to address the double use of K within an insurance group (for example where
regulated entities make subordinated loans to each other) and double leverage (where a
parent raises debt which is then used to fund an investment in a regulated subsidiary,
improving the solo capital position of the regulated entity).
Group reporting requirements
 Each insurance group must cover its overall group SCR
 Allowing for diversification benefits across the group
 Group solvency floor (sum of the MCRs, or local equivalent, for each insurance or Re entity within group).

 Each insurance subsidiary needs to cover its own SCR and MCR.
Solvency II
 Solvency II is not just a reporting framework, but a RM framework with implications for K allocation,
RM activities and performance management.

 Regime may also have an impact on the optimal product mix for the company, and on product design.

 Impact optimal asset mix for the company

 Diversification of risk and generate M &A activity.

 Management information is likely to align Solvency II metrics with strategic decision-making process.

 The impact on the market of the external disclosures also needs to be considered.
Solvency II
EIOPA = European Insurance and Occupational Pensions Authority
 The body of European supervisors that provided technical advice and support to the European Commission for
the development of Solvency II and is responsible for producing some of the additional guidance. The PRA is the
UK representative in EIOPA.

SCR = Solvency capital requirement

 An amount of capital that an insurance company must hold in addition to its technical provisions. The SCR can be
calculated using a prescribed standard formula or by using a company-specific internal model approved by the
regulator.

MCR = Minimum capital requirement

 An amount of capital that an insurance company must hold in addition to its technical provisions. The MCR is
lower than the SCR and is the ultimate point of supervisory intervention, i.e. the point at which an insurance
company would lose its authorization.
Solvency II
RSR = Regular Supervisory Report
 The RSR is a private report from the insurance company to the supervisor. It must contain certain pre-defined
sections.

QRT = Quantitative Reporting Templates

 The QRT are the quantitative parts of the private reporting from the insurance company to the supervisor.
They must be submitted annually (with a subset submitted quarterly).

SFCR = Solvency and Financial Condition Report

 The SFCR is the annual report that provides a company’s public (Pillar 3) disclosures.
ICA
 Hard to quantify operational risk
 Risk consistent with 99.5 % certainty solvency (within 1 year framework)
 Can use lower CI for a longer time-frame
 Market consistent techniques to be used
 May involve stochastic models
 Apply 1 in 200 shocks to risk factors
 Get worth of NB
 Probability of business closure
 Recalculate surplus K expected at end of period
 Determine K requirement using scenario testing
 Aggregation of risk – correlation matrix approach
Effect of Pillar 2
 Realistic liabilities increase because of higher claims
 Credit spread – widening
 Reduced market value of bonds
 Increased chance of defaults
 K availability lower
 Liquidity premium part of yield has increased
 How well A/L cash-flows match
 Ripple effects on economic indicators
Effect of Pillar 2
 Equity markets – fall
 Weaken solvency positions
 Asset values fall
 No change in liabilities (market consistent) except for unit linked
 Equities held for long term liabilities (pre-funded LTC)
Considerations
 Future 1 in 200 risk events
 Estimation of corporate bond risk events
 Liquidity risk events
 Correlation assumptions need to be reconsidered – ripple effects
 Volatility (projection of equity values)
 Test passed on further 1 in 200 positions
 Breach of K requirements
 Regulator – decide how to protect industry
 Any change in underlying risk free rate