Solvency II: the EU regulatory regime for insurers

This guide was last updated in March 2016

The directive is hugely important as it provides a framework for a new, harmonised solvency and supervisory regime for the insurance sector. The EU's intention is that this new regime will provide higher and more uniform levels of consumer protection, as well as promote competitive equality.

Scope

Solvency II applies to all EU insurers and reinsurers, including firms in run-off, with some exceptions. It will apply to more than 400 retail and wholesale insurance firms and to the Lloyd's insurance market in the UK alone.

Some smaller insurance firms will fall outside the scope of the directive, but may still apply for authorisation under Solvency II. These firms, which mainly consist of friendly societies, are referred to as Non-Directive firms, non-Solvency II firms or out-of-scope firms. In general, these are:

• firms with gross premium income below €5 million and 'gross technical provisions' of less than €25m. This refers to the economic value of insurers' liabilities;
• where the firm belongs to a group, the total of the technical provisions of the group does not exceed €25m;
• the firm does not include insurance or reinsurance activities covering liability, credit and suretyship insurance risks, unless they constitute ancillary risks; and
• the business of the firm does not include reinsurance operations exceeding either of: €500,000 of its gross written premium income or €2.5m of its technical provisions; or more than 10% of its gross written premium income or more than 10% of its technical provisions.

New regulation

Aspects of Solvency II that are completely new include:

• economic risk-based solvency requirements: introduced for the first time by moving away from the 'one model fits all' way of estimating capital requirements to more entity-specific requirements;
• a new 'total balance sheet' type regime and more comprehensive solvency requirements for insurers. Previously, insurers did not have to hold capital against market risk (i.e. decreases in investment values); credit risk (i.e. third party debt issues); or operational risk (i.e. systemic breakdown, malpractice etc.). This has changed under the new regime. The rationale is that these other risk types can also pose a material threat to insurers' solvency.
• a focus on identification, measurement and proactive management of risks as well as a more prospective focus for the first time. Where the old solvency rules for insurers focused on historical data, the new rules require insurers to take future developments into account including new business plans or the possibility of catastrophic events which might affect their financial standing. The Own Risk and Solvency Assessment (ORSA) is a new tool designed to assist with this;
• greater transparency and increased requirements to disclose certain information publicly, which is expected to enhance both supervision and competition;
• better management of insurance groups as single economic entities by strengthening the role of group supervisor.

The three 'pillars'

Solvency II is divided into three thematic areas known as 'pillars', much like the three-pillar approach to banking regulation introduced by the Basel II regime. Although each pillar sets out provisions relating to distinct areas, there is a strong interconnectedness between all three so Solvency II should be approached comprehensively.

Pillar I addresses adequacy of assets, technical provisions and capital of a firm. There are two sets of capital requirements: the more risk-sensitive Solvency Capital Requirement (SCR); and the lower and more formulaic Minimum Capital Requirement (MCR). The SCR may be calculated using a standard formula, or using an 'internal model' with regulatory approval.

Pillar II covers qualitative requirements: higher standards of risk management and governance. It gives supervisors greater powers to challenge firms on risk management issues. Firms are required to prepare and submit an ORSA to their supervisors, identifying the risks in their business and the capital needed to manage that risk.

Pillar III covers greater levels of transparency for supervisors and the public, through private annual reports to supervisors and public solvency and financial condition reports. Firms must provide more detailed information about their affairs on a quarterly and annual basis.

New governance requirements

Pillar II sets out new governance and risk management requirements for firms. The general requirements are that:

• a firm's governing body is responsible for the firm's compliance under Solvency II; and
• firms must have an effective governance in place appropriate to their business.

There are also a number of specific new requirements relating to internal control, internal audit, risk management, actuarial functions and outsourcing. Firms must ensure that written policies and effective risk management in relation to these are implemented.

Outsourcing implications

Although the UK's Prudential Regulation Authority (PRA) acknowledges the merits of outsourcing, the Solvency II rules have been designed to ensure due diligence of the supplier and appropriate contractual terms are in place so that the insurer retains control over any "critical or important operations, functions or activities". This is important because the insurer remains fully responsible for discharging all of its obligations under Solvency II and cannot delegate these to its suppliers.

For more information on the new regulatory requirements for outsourcing under Solvency II, see our separate Out-Law guide.

Calculating capital

Under Solvency II there are two required capital measures: the Solvency Capital Requirement (SCR) and the Minimum Capital Requirement (MCR).

The MCR represents the minimum level of capital that firms are required to maintain and is set at a one in 85 'confidence level': that is, an 85% probability that the firm will be able to meet its obligations over the next 12 months. This is the level below which a firm becomes insolvent for regulatory purposes.

The SCR is a risk-responsive capital measure calibrated to ensure that each individual insurer will be able to meet its obligations over the next 12 months with a probability of 99.5%. If this level of capital is not held, it is likely to result in regulatory intervention and require remedial action.

Implications for corporate groups

Insurance and reinsurance firms are sometimes part of complex group structures which can make it difficult for regulators to establish how group capital van be made available to individual entities within that group, or to assess the influence exerted by group members over insurance entities or activities. For this reason, Solvency II requires groups to be supervised on a holistic basis to enable the regulators to gain a coherent understanding of the risks that exist at group level.

The main group level requirements under the directive include the following:

• solvency calculations required at group and solo level;
• insurance holding companies and their insurance or reinsurance subsidiaries are jointly responsible for monitoring the group SCR;
• insurance holding companies must put in place systems and reporting procedures including appropriate systems of governance and written policies in relation to risk management, internal control, internal audit and, where relevant, outsourcing;
• significant risk concentrations at group level and significant intra-group transactions must be regularly reported to the group supervisor;
• all persons who effectively run insurance holding companies or have key functions required to satisfy the 'fit and proper' criteria;
• insurance holding companies must carry out an ORSA at group level; publish a solvency and financial condition report (SFCR); and provide a group regulatory supervisory report (RSR) to the group supervisor.

Impact on Part VII transfer process

Solvency II has had a number of effects on insurance business transfers under Part VII of the UK's Financial Services and Markets Act (FSMA). Some that we have observed include:

• an increased number of transfers taking place as insurers reorganise their businesses to achieve better capital efficiency to meet Solvency II capital requirements;
• the removal of some of the concepts which have traditionally been fundamental to and very common in the Part VII space including 'actuarial function holder' and 'long term insurance fund', in order to better align the terminology with the definitions and concepts in the Solvency II framework;
• judges referring to transferees holding sufficient capital under the Pillar I and Pillar II tests of Solvency II;
• the independent expert's report containing a section on whether the transferee's preparations for Solvency II are sufficient;
• the need for an additional certificate from the PRA regarding its consultation with EEA states confirming that the supervising authority in each EEA state other than the UK in which insurance contracts have been concluded by the firm has been notified of the proposed transfer.

Next steps

There were various developments in 2015 in relation to Solvency II not sufficiently accounting for insurers' investment in infrastructure projects. This led to the European Commission proposing a 'delegated regulation' amending the way in which infrastructure investments are treated under the Solvency II Delegated Regulations. If the European Parliament does not object, the delegated regulation will be published in the Official Journal and will come into effect later in 2016.