Background to Solvency II
On 5 May 2009, the Council of Ministers formally ratified the framework Directive for Solvency II that had been finally approved by the European Parliament in April. This ratification marked the end of the Level 1 (framework principles) phase of the Solvency II project to introduce a European-wide risk-based regulatory capital model for the supervision of insurance and reinsurance undertakings. The framework Directive indicates that this risk-based supervisory regime is to be implemented by 31 October 2012.
The basic premise of Solvency II is that undertakings themselves are responsible for the correct and adequate assessment of their own Solvency Capital Requirements. However, in order that regulatory supervision may be appropriately applied and in a manner that is proportionate to the level, scale and complexity of the business risks of the undertaking, the Directive sets out the principles and processes by which the adequacy of the solvency of an undertaking will be assessed.
Solvency II is based on a three-pillar structure, where each pillar has equal importance and relates to and links with the other pillars:
- Pillar 1 (capital charges) – establishes a risk based Solvency Capital Requirement (SCR) Model, an Internal Regulatory Approved Model or a combination of both (Partial). The Solvency II model sets an undertaking’s SCR based on a series of risk calculations applied to financial and accounting data. Whereas Solvency I considered only a small part of the financial aspects of an undertaking, the new model considers Asset Risks, Counterparty Risks, Underwriting Risks, Default Risks and Operational Risks. The model is both retrospective and prospective, considering past variations and future possibilities. Solvency II allows an undertaking to establish its own risk-based capital model but it will have to prove that its model is as robust as the SCR Model.
- Pillar 2 (supervisory review) – the relevant regulator will verify and approve any calculated capital charges and ascertain how well an undertaking meets all the compliance requirements set out in the Directive. These requirements include prudential and good governance requirements and extend to verifying the active integration of the SCR model in daily management processes. The regulator will verify that the Directive requirements for internal audit, internal control, risk management and actuarial functions are met. The undertaking will be required to prepare for the regulator an Own Risk and Solvency Assessment report (ORSA), which will consider all risks, including those set out in the Standard SCR model and wider business risks that might affect the undertaking.
- Pillar 3 (risk transparency) – aims to harmonise reporting to supervisors. This includes more extensive information, including that not normally in the public domain. Market transparency will be increased to provide better insight into the actual risk and return profile of each undertaking. All undertakings will be required to prepare a Solvency and Financial Condition report that will summarise and detail many of the aspects considered and reported on in Pillar 1 and Pillar 2.