Introduction and Overview
The Solvency II Directive proposal has the clearly stated aim of ensuring the financial soundness of insurance and reinsurance undertakings across the EU, in particular to ensure that they are able to withstand periods of difficulty. To do this, the proposal recognises the need for a greater degree of anticipation of future adverse events so they are handled better by (re)insurers. This signals a move away from the current reliance on historical data focusing almost entirely on liability risks, and it introduces asset side risk measures, including market, credit and operational risks.The Solvency II Directive has been drafted following the advice on Pillar I issues submitted by CEIOPS in March 2007. While the draft directive has ‘Solvency’ in its title, it explicitly notes that capital is not the only (or necessarily the best) way to mitigate against failures. Studies by CEIOPS of recent insurer failures and ‘near misses’ found that the primary causes of failure were poor management and inappropriate risk decisions, rather than capital inadequacy, per se.
This change of emphasis places a greater degree of reliance on risk management as a function within the undertaking and the proposal compels (re)insurers to instigate governance and risk management arrangements as the basis for ensuring adequate solvency. Also, solvency capital calculations are designed to be based on the specific risk profile of the undertaking, whether this is through the standard formula or an internal model.
The standard formula compartmentalises each risk category into a distinct module for capital purposes with an allowance for aggregation and diversification between the modules. Clearly, an internal model would better reflect the firm’s precise risk profile and management approach and provide a more useful management tool through the more sophisticated modelling of interactions between risks. However, this represents a greater implementation challenge and would need to be approved by the regulator.
The draft directive aims, therefore, to align risk measurement and management. Together with the requirement for private and public disclosure, they form the ‘3 pillars’ of Solvency II. Disclosure introduces two new requirements for firms: the Own Risk and Solvency Assessment (ORSA) and the Solvency and Financial Condition Report. The ORSA, in particular, is seen as a key tool for the regulatory authority as well as for management of the firm.
The proposed directive recognises that, while the aim is to harmonise regulation both across territories and across financial sectors, different firms will have different risk profiles. Therefore, the principle of proportionality should apply so that the requirements are not too burdensome on smaller organisations, whilst multi-national groups are able to obtain the benefits of diversification.Indeed, the smallest insurers have been excluded completely from the requirements, although they can ‘opt in’ to the new regulatory regime if they wish to share in the improved environment.
Multi-national groups will be regulated through the concept of a ‘group supervisor’ structure which, in co-operation with regulatory authorities in other territories, is intended to provide a streamlined, efficient and consistent approach and will perhaps allow more efficient group capital structures.
In recognition of the amount of work still required, both by the supervisory authorities and by insurance and reinsurance undertakings, the implementation date for Solvency II has been put back to 1 November 2012 with the expectation that implementing measures will be agreed in 2010.