Solvency II is a comprehensive regulatory framework that governs insurance and reinsurance companies operating within the European Union (EU). After several years of discussions, it came finally into force in January 2016 with the aim of better protection of policyholders and beneficiaries. This was necessary because of the impacts of the financial crisis in 2008.
The major points of Solvency II are as follows:
1. Risk-Based Capital Requirements
Solvency II employs a risk-based approach to capital adequacy. Insurance companies must maintain an appropriate level of capital based on their risk profile, taking into account various risks such as underwriting, market, credit, and operational risks.
2. Pillar Structure
Solvency II is structured around three pillars:
- Pillar I: Quantitative Requirements: This pillar sets out the minimum capital requirements that insurers must hold to cover their risks. It includes the Solvency Capital Requirement (SCR) for day-to-day risks and the Minimum Capital Requirement (MCR) as a threshold below which a company is not allowed to operate.
- Pillar II: Qualitative Requirements: This pillar focuses on governance, risk management, and the supervisory review process. It requires insurers to have effective risk management systems and governance structures.
- Pillar III: Reporting and Disclosure: Insurers must provide detailed information about their financial position, risk management practices, and solvency position to both regulators and policyholders. Transparency is a key element of this pillar.
3. Risk Categories
Solvency II categorizes risks into several key areas, including underwriting risk, market risk, credit risk, operational risk, and insurance and reinsurance risk. Each risk category is assigned specific capital charges based on a standardized approach or an internal model if approved by regulators.
4. Own Risk and Solvency Assessment (ORSA)
Insurers are required to conduct a regular self-assessment of their risk and solvency positions. This process, known as ORSA, helps insurers better understand their own risk profiles and assess whether they hold sufficient capital to cover potential losses.
5. Supervisory Review Process
National supervisory authorities play a crucial role in ensuring that insurance companies comply with Solvency II. They conduct regular reviews and assessments of insurers’ risk management practices, governance, and financial positions.
6. Group Solvency
Solvency II applies at both the individual company and group levels. Insurance groups are required to assess and manage risks on a consolidated basis, which means considering the risks and capital positions of all subsidiaries within the group.
7. Reporting and Disclosure
Insurers must provide detailed and transparent information to regulators and the public. This includes regular financial reporting and the publication of solvency and financial condition reports (SFCRs).
Solvency II has significantly improved risk management and capital adequacy within the European insurance industry, leading to increased stability and policyholder protection. It promotes a more harmonized regulatory framework across EU member states, ensuring a level playing field for insurance companies operating in the region.
However, as with every regulation, adaptions need to be made due to practical experience and changes in the market environment. Therefore Solvency II is currently under review.
On July 18 2023, the EU Parliament voted on the Solvency II reform and agreed on compromises for its amendments.
The main discussion points are as follows:
1. SCR standard formula
The SCR standard formula is the central point of Solvency II regulation, on the basis of which the minimum capital requirements are calculated. What is being discussed here is, in particular, the recalibration of the interest rate risk in order to better take the actual interest rate risk into account even in a negative interest rate environment.
2. Long-Term Guarantees and Equity Risk
When it comes to long-term guarantee measures, a method for extrapolating the yield curve is currently being discussed. This is intended to achieve better market consistency, although depending on the method, this can also lead to higher volatility. In the future, the volatility adjustment should take the long-term company prospects into account, which will lead to a reduction in short-term volatility. To this end, the GAR factor should be increased from 65% to 85%.
Important changes are also to be made with regard to equity risk. To this end, the corridor for systemic adjustment should be increased from +/-10% to +/-17%. In addition, the support of infrastructure investments is to be further expanded.
3. Small insurers
One of the most important points is the long-discussed relief for small insurers. These should be relieved by increasing the threshold for annual premium income from EUR 5 million to 25 million. At the same time, the threshold for insurance-related provisions should also be adjusted from EUR 25 million to EUR 50 million.
4. Sustainability
As part of the European Green Deal, sustainable capital investments should be better taken into account and promoted. It is also proposed that the standard formula for calculating natural disaster risks be adjusted more frequently to better reflect climatic changes.
The changes are scheduled to come into force on January 1, 2025. We will continue to keep you updated on important changes.
