Solvency II (Directive 2009/138) establishes a more sophisticated and harmonised risk based requirements for almost all insurers and reinsurers that take account of all risks that EU insurers and reinsurers face, not just readjusted risks.

It will replace some 14 existing directives. Solvency II will not apply to pension funds covered by the Occupational Pension Funds Directive. The Solvency II exemptions are very limited and include firms with gross annual premium income of less than EUR 5 million. However there are other conditions which have to be satisfied as well.

Solvency II will be supplemented by more detailed technical Commission Level 2 measures and they in turn will be supplemented by Level 3 guidance for national supervisors developed and adopted by the European Insurance and Occupational Pensions Authority .

Solvency II is based on a 3 pillar structure:

• Pillar 1 Capital Requirements
• Pillar 2 Governance and Risk Management Requirements
• Pillar 3 Disclosure and Transparency Requirements

Two Directives have amended Solvency II, a Directive extending the implementation date and another Directive titled the Omnibus II Directive which has not been fully agreed, with the result that it could be 2016 before Solvency II comes into force. The Omnibus II Directive, amendments to Solvency II include amendments giving the Commission power to define transitional requirements and to produce additional level 2 measures. Omnibus II also incorporates changes to ensure EIOPA can work effectively.

In December 2012, EIOPA published an opinion on Solvency II Interim Measures that national supervisors should be taking in the interim period, before Solvency II comes into force.

Pillar 1. Capital Requirements

Under Pillar 1, a firm needs to have sufficient capital to cover technical provisions (Reserves), the minimum capital requirement (MCR) and the solvency capital requirement (SCR). Together all three are known as Own Funds.

The Directive introduced the concept of ringfenced funds which impact Own Fund items. That means they can only be used to cover losses arising either from a particular segment of liabilities, from particular risks, or in respect of particular policy holders.

An adjustment to Own Funds will be required to reflect the fact that items within the ringfenced funds are not available to absorb losses outside the ringfenced funds.

The MCR is intended to represent the minimum level of capital that insurers and reinsurers are required to maintain (Article 128). Firms will have to calculate their MCR once a quarter and report the results of their MCR calculations to their supervisor on a quarterly basis. Firms will also need to publicly disclose their MCR.

The SCR is the maximum level of capital that insurers and reinsurers are required to maintain (Article 100). Firms will be required to report the results of their SCR calculations to their supervisor at least once a year. More frequent reporting will be required where a material change in risk profile occurs. Articles 100 to 127 prescribe how the SCR is to be calculated.

Articles 93 to 98 divides Own Funds into three Tiers with Tier 1 Own Funds have the highest level of performance and loss absorbency and Tier 3 Own Funds have the lowest level. The Directive imposes quantative limits on the proportion of each Tier that can be treated as eligible to cover the SCR and the MCR.

Article 91 provides for a member state option that permits surplus funds to be eligible for inclusion in a firm’s Tier 1 capital under certain conditions ( rather than being included as insurance or reinsurance liabilities in the firm’s technical provisions). Surplus funds are accumulated profits that have not been made available for distribution to policy holders and beneficiaries that satisfy the criteria set out in Article 94(1).

The prudent person principle is a new concept related to asset management and investment. Solvency II will give firms greater freedom as regards the assets they can invest in, in order to cover technical provisions or reserves and will as a consequence amend the Consolidated Life Directive. The prudent person principle (article 132) will be applied to all assets of the firm. Applying this principle, firms will be required to only invest in assets and instruments whose risks they can properly identify, measure, monitor, manage, control and report. All assets to be invested in such manner as to ensure the security, quality, liquidity and profitability of the portfolio as a whole.

Assets held to cover technical provisions must be invested in a manner appropriate to the nature and duration of the insurance and reinsurance liabilities. Assets must be invested in the best interests of policy holders and beneficiaries taking into account any disclosed policy objectives.

Pillar 2. Governance and Risk Management Requirements

Articles 38 and 40 to 50 set out the requirements for firms as regards governance and risk management. A firm will be required to have in place an effective system of governance that provides for the sound and prudent management of its business. Outsourcing is regulated by article 49 and the fitness and probity of board members and senior management is regulated by article 42.

Arising from Article 44, the firm is required to have in place a risk management system. The system needs to be able to identify, measure, monitor, manage and report on a continuous risk basis all risks that the firm could be exposed to (covering both risks included in the SCR and risks wholly or partly excluded from the SCR).

As part of having an effective system of governance, firms are required to establish certain key governance functions being risk management (Article 44), compliance (Article 46), Internal Audit (Article 47) and Actuarial (Article 48).

Assessing a firm’s own risk and solvency Under article 45 firms will be required to regularly assess, their overall solvency needs based on their risk profiles, risk appetites and business strategies, their compliance on a continuous basis with the Solvency II capital requirements and the significance with which their risk profile deviates from the assumptions under their SCR calculations. This review is known as the Own Risk and Solvency Assessment (ORSA). Each firm will be required to carry out an ORSA regularly and following a significant change in risk profile. The results of each ORSA must be reported to the firm’s supervisor. EIOPA has published guidelines on the ORSA.

Finite reinsurers article 210 requires firms that conclude contracts of finite reinsurance or carry on finite reinsurance activities to have adequate systems of governance in place to identify, measure, monitor, manage, control and report the risks arising from the contracts or activities.

Capital Add-ons supervisors will be able to in exceptional circumstances impose a capital add on if they consider a firm’s risk profile deviates significantly from the assumptions underlying its SCR or if there are significant governance deficiencies (article 37).

Pillar 3. Disclosure and Transparency Requirements

Pillar 3 covers supervisory reporting and disclosure and Articles 35, 51, 53 and 55 prescribe reporting requirements including they detail the information that firms must submit to their supervisors to facilitate their supervision.

Firms will be required to publish an annual report that provides detailed information on the firm’s solvency and financial condition (Article 51). This report is known as a “Solvency and Financial Condition Report” (SCFR). The SCFR must include information on (the following are only some of the required inclusions):

• the firm’s business and its performance, its system of governance and assessment of the system’s adequacy for the firm’s risk profile.
• a description of the firm’s capital management including:
  • information on the amount and structure of own funds.
  • the amount of the MCR and SCR.
  • any non compliance with the MCR or significant non compliance with the SCR during the reporting period and information as to the main differences between the underlying assumptions of the standard formula and those of any internal model used by the firm.

Supervisors have the power to allow firms not to disclose information in their SCFRs if it would result in an unfair advantage to their competitors or it is the subject of a secrecy or confidentiality undertaking (Article 53). However, firms have to provide this type of information to their supervisors by way of a regular private report. This report is known as the report to the supervisor or regular supervisory report.

Treatment of Groups: Articles 212 to 266 contain provisions designed to strengthen the supervision of insurance groups.

Treatment of Insurance for Special Purpose Vehicles (ISPV): Article 201 requires member states to allow the establishment of ISPVs subject to supervisory approval. Most of the substantive requirements for ISPVs will be contained in the Level 2 measures which are expected to prescribe the scope of authorisation.