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The Actuary The magazine of the Institute & Faculty of Actuaries

Solvency II

T he existing European Solvency I requirement is regarded throughout Europe as a simple formula that is not sufficiently sensitive to risk. In addition it is widely recognised as being calibrated at too low a level of capital. Hence, most regulators across Europe have informally expected companies to hold twice that amount of capital.
Solvency II represents a giant step forward in the regulation of EU insurers and reinsurers, introducing a more transparent risk-based regulatory framework. It not only deals with capital but also adequacy of provisions and asset rules.

Pillar talk
The new Solvency II system has a three-pillar approach to supervision (figure 1). This is similar to the Basel II structure introduced for banks, which has quantitative capital requirements (pillar I), a supervisory review process (pillar II), and disclosure requirements (pillar III).
Pillar I will consist of two levels of capital requirement, the minimum capital requirement (MCR) and the higher solvency capital requirement (SCR). The SCR may take the shape of a risk-sensitive company-specific formula, incorporating an incentive to move towards using internal (full or partial) models.
The regulator is likely to assess the link to the firm’s risk management and whether there has been appropriate validation of internal models. This assessment may include focus on both the risk controls and change controls surrounding the individual firm’s capital assessment.
Greater attention will be paid to governance and internal controls. Major risks must be identified. Also, policy documents should be in place, clear reporting lines must exist, and responsibilities should be defined. Similarly to the UK, it is particularly important that senior management and the board are involved.
Greater consistency between financial sectors and between countries will become the norm. How the principles must be applied at both group level and legal entity level is being discussed. Smaller firms may use less sophisticated methods because of the nature and scale of the business.
The aim is for the supervisory reporting to be compatible with the accounting rules of IFRS. This is to ensure convergence in financial and regulatory reporting, and to limit the administrative burden for supervised institutions. The delays experienced in IFRS may hence prevent Solvency II from following the desired timetable.

Solvency II versus ICAS
The Individual Capital Assessment Standards (ICAS) framework in the UK already features a number of the above properties. However, with the EU striving for greater harmony between reserving, asset rules, and regulatory capital, Solvency II is likely to have an effect on UK companies.
Areas that are currently under consultation and could change the way we operate in the UK include:
– introduction of risk margins in addition to the best estimate reserves;
– disclosing requirements and reports on actuarial work and judgements;
– guidelines and rules for internal models;
– approaches to allowance for outwards reinsurance;
– new solvency calculations.
In the meantime, the strong emphasis on risk and capital management brought by ICAS will bring the UK down the route that the EU is aiming for.

The political process
Solvency II is driven by the European Commission with the aim of introducing a more risk-sensitive solvency system that provides the supervisors with the appropriate tools and powers to assess the ‘overall solvency’ of an insurance firm. (See figure 2 overleaf.)
The Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) will provide technical advice in the context of the Solvency II framework. The ultimate decisions are likely to be taken by the EU Council of Ministers, after they have received advice from CEIOPS and the EU Commission and consulted with a number of European bodies including:
– The Comité Européen des Assurances (CEA), representing the European insurance industry (including the Association of British Insurers).
– The European Actuarial Groupe Consultatif, representing the actuarial profession across the EU.
– The Fédération des Experts Comptables Européens (FEE), representing the accounting profession.
In addition to these, there are groups such as the CRO forum that are lobbying in the interests of those they represent. Within different national markets, groups have also been set up to respond and raise awareness. For example, the UK Treasury ran a round table group to discuss Solvency II.
The number of people involved in some capacity in the process of producing the Solvency II framework is vast. It will be a challenge to produce a new system that achieves the objectives and is also practical to implement across countries currently operating at various levels of sophistication.

The dates the European Commission is working towards are:
– Preparation of a draft proposal for a framework directive before the end of 2006;
– Solvency II legislation to be implemented by the end of 2010.
Clearly this is a tight and challenging timescale for a system that will bring large changes to the way insurance companies will be working and reporting in the future. It is still too early to know what kind of transitional arrangements may be considered.

UK actuarial input
The UK profession’s input is via the Groupe Consultatif. If you are interested in joining the UK Solvency II working group on general insurance, please contact Peter Stirling, email peters@actuaries.org.uk.