Solvency II � Frequently Asked Questions � What is Solvency II by jackshepherd


									                     Solvency II – Frequently Asked Questions

   •   What is Solvency II?

Solvency II is the name of the proposed new European Directive for insurers
covering their capital requirements and related supervision. It is expected to
come into effect in 2010 or 2011, though a draft Directive setting out the key
elements of the proposed framework will be published by the European
Commission in July 2007, for consideration by the European Parliament.

Solvency II will replace a series of existing European Directives, some dating
back to the 1970s and will overtake a number of requirements currently
imposed by individual national regulators.

Solvency II is set to introduce a more modern, risk-based approach using
market consistent methods for the valuation of insurers’ assets and liabilities.
This means wherever possible actual market prices are used. Where these
are not available market-based techniques are used, to establish what a fair
price would be for the sale of an asset or liability between a willing buyer and
seller. This would include an economic assessment of the value of all options
and guarantees provided in any insurance contracts.

Taken together, the promised reforms should deliver a more proportionate
regime of supervision, with risks properly identified and capital matched
accurately to mitigate these risks. Solvency II should also see a much greater
consistency in the supervision of insurance firms across Europe.

   •   What are the key dates for the development and implementation
       Solvency II?

The European Commission have promised to publish a Framework Directive
by July 2007, which will be submitted to the European Parliament for their
consideration. Approval of the final Directive may be expected in late 2008 or
early 2009, with implementation expected from 2010.

Whilst the Directive will set out the overall framework for Solvency II, many of
the detailed requirements will be set out in ‘implementing measures’ which will
be developed in parallel by the Commission under the Lamfalussy process.

An extensive consultation process is being undertaken by the European
Commission and the Committee of European Insurance and Occupations
Pension Scheme Supervisors (CEIOPS) to seek stakeholders views in
developing the Solvency II Directive. The Commission issued a framework for
consultation including three waves of ‘calls for advice’, upon which CEIOPS
issued consultation papers and subsequently provided advice to the
Commission. At the end of 2006, CEIOPS issued a further set of consultation
papers (CPs 15 to 20) that returned to a number of these subjects, seeking to
provide further, more detailed advice. Responses are due from stakeholders
in January 2007, following which CEIOPS will provide its advice to the

An important part of this process will be the third Quantitative Impact Study
(QIS3), running from 1 April to 30 June 2007. The results of this exercise will
provide a significant input into the final calibration of the Solvency II

   •   I’ve heard something about the ‘Lamfalussy process’ – how will
       this affect the Solvency II Directive ?

The Lamfalussy process has been adopted by the European Parliament as a
more flexible basis on which to develop and implement new legislation.
Lamfalussy provides a mechanism to update the detailed specifications in a
Directive such as Solvency II, as market conditions and other circumstances
change, whilst securing the principles and key requirements in primary
legislation. The Parliament also retains a right to ‘call-back’ the legislation if it
wishes to review the implementation or revise the effect of the legislation it
has passed in the light of experience.

In essence, Lamfalussy introduces a four-level regime;

Level 1 - Primary legislation defining broad ‘framework principles’.

Level 2 - Technical implementing measures to be adopted by the

Level 3 - Working arrangements and common practice agreed amongst
national supervisors to ensure consistent application of Level 1 and Level 2

Level 4 – Enforcement by the Commission to ensure consistent
implementation of EU legislation


   •   What will be the benefit of Solvency II for consumers?

Solvency II should reduce the risk of failure or default by an insurer, with
improved identification, understanding and monitoring of risk. Risks will be
more clearly identified and action taken more quickly to address problems as
they arise – particularly unplanned or unexpected events.

A more consistent and open regulatory framework should make it easier for
companies to sell across different markets, promoting competition; whilst
more sophisticated assessment of insurers’ capital requirements should mean
they are no longer required to hold excess capital, which increases costs and
makes insurance and investment contracts more expensive than they need to

Removing arbitrary restrictions, such as those on investment strategy or
product design should also enable insurers to provide a broader range of
products to consumers that can better match their individual requirements.


   •   What will be the benefits of Solvency II for insurers?

Solvency II should bring a number of benefits for insurers. The new regime
will have a much greater focus on risk assessment and transparency, rather
than arbitrary restrictions and unmeasured prudence.

Market-based valuation of assets and liabilities will improve transparency and
enable both firms and supervisors to better understand the underlying
financial position of the insurer. Solvency II will also see a much greater role
for firms’ own internal risk and capital assessments, including their own
internal capital model (see definition below), to provide a significant input to
the supervisor’s assessment of the firm.

A more streamlined and proportionate regulatory regime should reduce
burdens on insurers, reducing costs and increasing flexibility. Also under
discussion is a new approach for the supervision of large insurance groups
(see HMT/FSA paper on group supervision). This would see a single ‘lead
supervisor’ being responsible for the prudential regulation of the whole group,
leading one coherent assessment of the risk and capital position of the group
and all its entities, working together with supervisors in the other markets in
which the group operates. This contrasts with the current approach, where
separate assessments are undertaken by different supervisors to different
standards. This can result in considerable inconsistency and duplication of
effort and prevents the group from optimising its capital management and risk
mitigation strategies and frustrates the proper recognition of diversification

   •   How will smaller insurers be treated under Solvency II?

Solvency II will recognise the needs of smaller insurers in a number of ways:

First, the current exemptions under Solvency I for the smallest insurers are
expected to be carried over to Solvency II, meaning that the existing, local
arrangements for the supervision of the smallest entities can continue under
Solvency II.

Second, there will be a ‘standard approach’ for the calculation of the
‘Solvency Capital Requirement. This will provide a framework enabling small
companies without their own models to undertake the required solvency
calculations using more elementary data which they will already have
A key principle underlying Solvency II is proportionality, so the requirements
imposed on a company will reflect the risks they pose and can better
recognise the particular circumstances of each firm.

   •   Will Solvency II accelerate consolidation in the market?

Solvency II is not seeking to impose a single structure on the market, instead
the nature and organisation of insurers should be driven by economic logic.
Solvency II will not stop an established trend toward consolidation, but equally
companies who specialise and manage their risks effectively should also
prosper under Solvency II.

   •   How will mutual insurance companies be treated under Solvency

The Solvency II consultation process includes consideration of the particular
circumstances of mutuals, looking at member calls and their contribution to
the capital strength of the insurer. The interests of smaller and specialist
insurers, many of whom are mutuals, have also featured in the consultation

   •   Will the implementation of Solvency II result in insurers holding
       more or less capital?

We believe that overall the level of capital currently held in the industry is
sufficient and so Solvency II should not lead to a significant change in the total
amount of capital held. However, there may be changes in the amount of
capital held by individual insurers, with a greater alignment of capital to risk.

   •   What is an ‘internal capital model’?

Many insurers will have a model, typically a sophisticated computer-based
system to forecast the future pattern of cash-flows using a framework of
financial and economic assumptions. These models will normally provide a
projection of the changes to the value of assets and liabilities at different
future dates using a series of assumptions set by the firm. Typically, the
model will allow a range of different scenarios (including disaster scenarios) to
be applied to assess the effect on the value of assets and liabilities. One of
the aims of an internal capital model is to determine what is the appropriate
level of capital for the firm’s business.

The development and use of an internal capital model is usually aligned with
the more general risk modelling work undertaken by firms to document,
describe and understand the risks in their business, the factors that affect
these risks and the tools they can use to mitigate these risks.


   •   What are the benefits for regulators?
Regulators will have a better understanding of the firms they are regulating.
The information they receive will more clearly identify the key risks in the
business. This will ensure supervisors can take earlier action where risks
emerge, which should reduce the risk of failure and enable them to
concentrate their efforts on those firms and those areas where there is the
greatest risk to consumers and to the financial system generally.

   •   What would be the role of regulators in smaller insurance markets
       under a lead supervisor regime?

Under the proposals put forward by the UK for a ‘lead supervisor’ (See
HMT/FSA paper [add link]) for an insurance group, local supervisors would
have an important role in monitoring the activity of the group in the local
territory and any subsidiaries based there. Whilst the lead supervisor would
take the initiative on key areas of group regulation to ensure a consistent
approach is applied across the group, we would see supervisors in each local
market forming a key part of the process, applying agreed monitoring
requirements and implementing appropriate regulatory tools. The local
supervisor would be responsible for ensuring that all local entities were in a
position to meet both the technical provisions and have sufficient capital to
support the Minimum Capital Requirement (MCR).

By contrast, CEIOPS propose a more conservative approach, with
supervisory powers largely exercised at the level of each legal entity,
essentially in line with the current arrangements under Solvency I. We believe
this does not align with the way in which most groups manage their
businesses and will fail to deliver an appropriate and effective supervision
regime for cross-border groups.

   •   Do we need a single EU regulator?

The vast majority of insurance firms operate in a single EU jurisdiction. For
those cross-border groups with more than one supervisor, we believe that the
lead supervisor model, as set out in the HMT/FSA paper [link], would ensure
an effective and streamlined approach to supervision.

   •   What are ‘MCR’ and ‘SCR’ under Solvency II

These are the two key control levels for capital assessment. The SCR is the
Solvency Capital Requirement. It is the normal, target level of capital an
insurer will be expected to hold. It will be calibrated to enable the insurer to
withstand a single 1-in-200 year negative event and still meet all its liabilities
to policyholders. Where an insurer’s capital reserves fall below the SCR level,
this is likely to trigger supervisory intervention. The cause and extent of the
breach and the speed at which the insurer’s capital position has deteriorated
will influence the nature and degree of action taken by the supervisor.

The MCR is the Minimum Capital Requirement. This is the absolute minimum
level of capital that an insurer must hold at all times. If the insurer were to fall
below this level of capital, this would trigger the most extreme supervisory
intervention. Typically, the firm would then be prevented from writing new
business and the regulator may initiate proceedings to wind up the company
and transfer its insurance assets and liabilities.

   •   What are Pillar 1, and Pillar 2 and Pillar 3?

The new framework of regulation under Solvency II will consist of three pillars,
covering internal risk and capital assessment, qualitative review and external
disclosure. These are described more fully below :

Pillar 1 comprises the main quantitative capital assessment process, which
will produce a calculation of the amount of capital a firm needs to hold to
mitigate its risks. Firms can undertake this assessment either by using their
own internal model, or by using the ‘standard approach’ provided for in the
Solvency II Directive.

Pillar 2 is a qualitative assessment process undertaken by the supervisor. At
this stage the supervisor reviews the firm’s Pillar 1 capital assessment and
considers whether there are any risks or factors that have not already been
fully captured in the firm’s own capital assessment. The supervisor will also
assess the firm’s systems and controls and other governance related issues
as part of the Pillar 2 assessment.

Pillar 3 refers to the public disclosure of information, including regulatory
returns and other data suitable for publication, to help the markets, investors
and policyholders better understand the nature of the business of each
insurer. This provides a separate and important discipline. The intention is to
build on existing publications where possible and only require additional
disclosures as a form of ‘top-up’, to avoid unnecessary duplication. However,
there is no certainty that an alignment will be achieved between the
requirements of Solvency II and international accounting standards.

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