Solvency II Brochure_FINAL-Low Res

8/8/2019 Solvency II Brochure_FINAL-Low Res

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Solvency IIUnderstanding the Directive


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The European Union Solvency II Directive is due to beimplemented by 2012. Covering over 30 countries itis the biggest ever exercise in establishing a single seto rules governing insurer creditworthiness and riskmanagement.

For companies its impact is ar-reaching. It is not simplyabout the technical calculation o capital reserves, but alsoabout each companys approach to risk management rom strategic decision-making to ensuring that allemployees understand their responsibility or risk.

With oices around Europe, EMB can assist in many ways.We have substantial experience with the definition and

development o internal models, based around our marketleading sotware EMB Igloo Proessional. EMB BusinessConsultancy can advise on the regulatory requirementsand the development o a risk management strategy.EMB Proessional Development can run educationprogrammes improving skills and understanding or allroles and all levels o personnel within your company.

The companies who will thrive under Solvency II will bethose companies who embrace the reorms, not as aregulatory burden but as an opportunity to strengthentheir organisation through best practice. EMB can helpyou achieve that.


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Introduction and Overview

With this greater emphasis on risk management, theproposal compels (re)insurers to instigate governanceand risk management unctions and policies as thebasis or ensuring adequate solvency continuously.

The Directive stipulates that solvency capitalcalculations, whether based on the standardormula or an internal model, should be alignedto the speciic risk proile o the undertaking. Thestandard ormula categorises risks into modules orcapital purposes with an allowance or aggregationand diversiication across the modules. Aninternal model would relect a irms risk proileand management approach more precisely, andthe sophisticated modelling o risk interactions ishighly useul or ongoing management. However,this presents a more signiicant implementationchallenge and will need regulator approval.

The drat Directive thereore aims to align riskmeasurement and management. Together withthe requirement or private and public disclosure,these orm the 3 pillars o Solvency II. Disclosureintroduces two new requirements the OwnRisk and Solvency Assessment (ORSA) and thesolvency and inancial condition report. TheORSA in particular is seen as a key tool orcompany management as well as the regulator.

The Solvency II Directive has been drated ollowing theadvice on Pillar I issues submitted by CEIOPS in March 2007.While the Directive has Solvency in its title, it explicitly statesthat capital is not the only (or necessarily the best) way tomitigate ailure. This is supported by recent CEIOPS studieso insurer ailure and near misses which ound the primarycauses o ailure were poor management and inappropriaterisk decisions, rather than capital inadequacy per se.

Pillar 1

QuantitativeRequirements

Balance sheet

evaluation

Solvency Capital

Requirement (SCR)

Minimum Capital

Requirement (MCR)

Pillar 2

QualitativeRequirements

System o

Governance

Own Risk & Solvency

Assessment (ORSA)

Supervisory

Review Process

Pillar 3

Disclosure

Annual published

solvency & inancial

condition report

Inormation provided

to the supervisors

Link with IFRS 2


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Lloyds o London is an interesting case in thatit is presently supervised by the UK FinancialServices Authority as a single entity under theauspices o the Society o Lloyds, and marketopinion suggests this is likely to continue.

The process will probably be similar to the currentICAS regime, although the model approvalprocess is likely to be more rigorous and increaseddisclosure required. However, Lloyds is likely tocontinue to be treated as a special case comparedto other groups. Since it does not meet criteria suchas the ability to move capital between entities tosupport grouplevel solvency, it will be unable togain the ull beneits o grouplevel supervision.

The Solvency II Directive itsel covers theEuropean Economic Area (EEA) includingNorway, Lichtenstein and Iceland, as well as the27 countries o the European Union. A numbero other country regulators, including Japan, arewatching Solvency II with a view to introducingsimilar riskbased capital regulation locally.

In recognition o the signiicant amount o workstill required, both by the supervisory authoritiesand by insurance and reinsurance undertakings,the proposed implementation date or SolvencyII has now been put back to 1 November2012 with the expectation that implementingmeasures will need to be agreed in 2010.


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Under Solvency II irms will be required to meet regulatory principlesrather than rules. The proposed regime acknowledges that some types orisk are best addressed through good governance rather than by simplyallocating additional solvency capital.

Governance and Risk Management

Through the Supervisory Review Process (SRP),the supervisor will rate the capability o the irmsgovernance system to identiy, assess and managethe risks and potential risks it aces as a business.The supervisor will have the power to orce irms toremedy any apparent weaknesses and deicienciesin the governance system, including strategies,processes and reporting procedures, so as toincrease conidence in the overall solvency position.

The onus is on the irm to demonstrate its

governance (including corporate governance) andrisk management are sound, appropriate or itsspeciic risk proile, and can be reviewed by thesupervisor. This will require documentation o:

policies and procedures

roles and responsibilities

reporting and Management Inormation (MI)

The governance system will support sound andprudent management o the business. It must beproportionate to the nature, scale and complexity o

the irms operations and it must be subject to regularreview.

The governance system must also include:

an adequate and transparent organisationalstructure with a clear allocation and segregationo responsibilities and an eective system orensuring the transmission o inormation

written and implemented policies or at leastrisk management, internal control, internal auditand any outsourcing. These policies should be

reviewed annually, or or any material change

An eective risk management system will be key.It must include strategies, processes andreporting procedures to monitor, manage andreport the irms risks continuously. The risks willneed to be addressed individually, in aggregate,and in relation to their interdependencies.

The risk management system must be wellintegrated into the organisational structureo the irm and as a minimum, cover:

underwriting and reserving asset liability management

investment, in particular derivativesand similar commitments

liquidity and concentration risk management

reinsurance and other risk mitigation techniques

I a partial or ull internal model is deployed orsolvency purposes, the irm will need to demonstratethat it is embedded in the risk managementsystem. The risk management unction will

thereore have additional responsibilities inrelation to the internal model, including:

design and implementation

testing and validation

documentation including maintenance

analysis and reporting on its perormance

model improvement and enhancement


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Key points

Solvency II is based on principles not rules

The irms governance and riskmanagement must match its risk proile

An eective risk managementsystem is key to governance

Internal models used or SolvencyII must be embedded into the irm,including strategic decisionmaking

A risk management unction, i not alreadyin existence, needs to be established

Since eective risk management is a continuousprocess, a risk management unction will have to beestablished i it does not already exist. Under theprinciple o proportionality, this does not necessarilyimply the need or a ulltime Chie Risk Oficer(CRO). However, the risk management unction mustbe demonstrably objective and independent, andwhilst the Directive allows that unctions such as riskmanagement can be outsourced, in practice this islikely to be only appropriate or smaller insurers.

Outsourcing is an issue that concerns regulatoryauthorities, particularly in relation to the degreeo control o outsourced unctions and the levelo governance applied. Thereore, supervisorswill have the right to access all relevant data heldby the outsourcing service provider as well asthe right to conduct onsite inspections, within oroutside the EU. Supervisors must also be inormedin an adequate and timely manner, o importantactivities being outsourced or any subsequentmaterial changes. Firms need to ensure outsourcingcontracts are constituted and managed eectively.


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Key Points

The supervisor will assess both

quantitative and qualitative compliance The supervisor is empowered to

require irms to remedy deiciencies

Supervisory Review Process (SRP)

The supervisor will regularly review and evaluate both the qualitativeand quantitative compliance o the irm in relation to its operatingenvironment and risks, current or potential.

The review will consider:

the system o governance and risk assessment

the technical provisions

the capital requirements

the investment rules

the quality and quantity o own unds

the use o a ull or partial internalmodel, i deployed

Supervisors will determine the requency andexact scope o each review and will use monitoringtools to identiy any inancial deterioration

o a irm. The objective is to assess irmsability to withstand possible adverse eventsor uture changes in economic conditions.

Following the review, the supervisor can require theirm to remedy any weaknesses or deiciencies. Acapital addon can be imposed in strictly deined,exceptional circumstances, particularly i therisk proile o the irm deviates signiicantly romthe assumptions underlying the solvency capitalcalculation, or there are concerns regardingthe governance standards within the irm.

While it is anticipated that a capital addon will bea temporary measure, it may become permanent ithe deviation o the risk proile is material, and thedevelopment o the internal model is ineficient. Thesupervisor can also require the irm to develop aull or partial internal model i the standard ormuladoes not accurately capture the risk proile.


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The irm should monitor its actual capital positionagainst the SCR on a continuous basis, and recalculatethe SCR as soon as the risk proile o the irm undergoes

any material change i.e. i the assumptions underlyingthe existing SCR are no longer valid. The SCR must becovered by an equivalent amount o assets in excess oliabilities. I the SCR is not covered then the irm mustsubmit a recovery plan to the supervisor and will beclosely monitored to ensure compliance with this plan.

The SCR is intended to relect all quantiiable risks thatthe irm might ace, including:

nonlie underwriting risk

lie underwriting risk

special health underwriting risk

market risk

credit risk

operational risk

It will correspond to the valueatrisk o the net assetso the irm subject to a conidence level o 99.5% overa oneyear period, assuming continued solvency.

The Minimum Capital Requirement (MCR) is a lowerlevel o capital suficiency below which authorisation

could ultimately be withdrawn. The precise detailso the MCR have yet to be decided, but it will becalculated quarterly and is likely to be calibratedto a conidence level o between 80% and 90%.

Firms can calculate the SCR in one o two ways:

useofthestandardformula

useofaninternalorpartialinternalmodel

Solvency Capital Requirement (SCR)

The Solvency Capital Requirement (SCR) is the new solvencystandard or irms, to be calculated annually, reported to thesupervisor and published.

The standard ormula is designed to be more risksensitive than the current approach and covers thewhole spectrum o risks aced by the (re)insurer. Thelines o business that the irm writes, the durationo liabilities and the assets held are all considered,together with explicit allowance or other riskscurrently excluded, such as operational risk.

The ormula has a module or each o the above risktypes. An SCR or each risktype (except operationalrisk) is calculated, with each module calibrated to

the oneyear 99.5% level. The results are thenaggregated, with diversiication eects governedby a correlation matrix. A separate loading oroperational risk (details to be decided) is then added.

Subject to approval by the supervisor, a irm mayreplace a subset o the standard ormula SCRparameters by parameters speciic to the irmwhen calculating the lie, nonlie and special healthunderwriting risk modules. The detailed parametersin the ormula are still to be speciied, and are subjectto urther analysis and consultation with the industry.

Key Points

The Solvency Capital Requirement

(SCR) is the new solvencystandard, calculated annually

The SCR covers all risks aced by the irmor a 1in200 year conidence level

The SCR can be calculated using either thestandard ormula or an internal model

The standard ormula is more risksensitive than the existing standard

The Minimum Capital Requirement(MCR) is a lower solvency standard


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Firms also have the option o a partial model, withsome components o the standard ormula SCRreplaced by results rom an internal model. However,supervisors will closely scrutinise these modelsto ensure that they are not just cherrypickingthose elements that can provide capital relie.

Some irms may be required to develop a (ull orpartial) internal model i the supervisor considersthat their risk proile deviates signiicantly romthat assumed or the standard ormula SCR. It isalso likely that some irms may come under peerpressure to develop internal models rom similarirms that have a more sophisticated approach.

To use an internal model irms require priorsupervisor agreement. Although the Directivestates that approval will take six months, thissounds like a tall order, particularly i many

applications are received in a short period o time.

As part o the initial approval process irmsshall agree with the supervisory authoritieson a policy or any model changes (major andminor) and then adhere to that policy. Any majorchanges to the model or the policy shall alwaysrequire prior supervisory approval; it will beinteresting to see how this will work in practice.

To achieve approval a irm must demonstrate that themodel passes a use test, meets particular statistical

quality standards, and is capable o being calibratedto the oneyear 99.5% level as speciied in the SCR.

Internal Models

The introduction o internal models as a mechanism tocalculate the SCR is a new departure in Solvency II. An internalmodel allows a much more bespoke assessment o a particularbusiness and its potential risks than can ever be replicatedin a standard ormula, and has the potential to be a useulmanagement tool. Internal models are already in common usewithin the larger and more sophisticated irms in Europe andthe Directive is clearly endorsing the use o these models orrisk management and regulatory purposes.

The use test requires that the model is embeddedwithin the system o governance, is a key tool indecisionmaking processes, and is updated regularlyto relect the irms risk proile. Even when approvalis given, irms must provide the supervisor with anestimate o the standard ormula SCR or two years.

Firms will need to justiy the assumptions underlyingtheir model. They may take into account uturemanagement actions that they would reasonablyexpect to carry out in speciic circumstances, as longas the model makes allowance or the time necessaryto implement such actions. Supervisors mayrequire irms to run their internal model on relevantbenchmark portolios and use assumptions based onexternal, rather than internal, data in order to veriythe calibration and to check that it is in line withaccepted market practice. This will mean that modelswill need to be suficiently lexible to allow this.

The model should be regularly validated,particularly against actual experience, so theirm can demonstrate to the supervisor that theresulting capital requirements are appropriate. Inparticular, sensitivity o the results to changes inkey underlying assumptions should be tested.

The model should be thoroughly documented,including an outline o the model design anddetails o the methodology, data and assumptionsused. Major changes to the previous version

o a model should also be documented.


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Key Points

Internal models should be tailored tothe speciic nature o the business

Internal models also provide an extremelyuseul management tool beyond compliance

Internal models must be approvedby the supervisor beore use

Firms can also deploy a partial modelalongside the standard ormula

Internal models will have to pass the use test

and be seen to be embedded in the company


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Own Risk And Solvency Assessment(ORSA)

Firms should highlight areas where they believethe assessment deviates signiicantly rom theassumptions underlying the SCR calculation.The submission must also include detailso the methods used and, where an internalmodel has been deployed, a recalibration thattransorms the internal results so that theyare consistent with the SCR calibration.

Firms will need proper processes in place oridentiying and quantiying their risks in a

coherent ramework. These processes must besuficiently streamlined so there is no unduedelay in updating the assessment ollowing anysigniicant change in the businesss risk proile.Firms must also demonstrate that this assessmenthas an inluence on strategic decision makingand is not just a boxticking technical exercise.

It is clear that the SCR standard ormula isinappropriate or the ORSA. Supervisors will want tosee an internal assessment that relects the speciicrisks aced by the irm based on internal data.Firms with internal models should ind this to

be airly straightorward as the ORSA will mostlikely use the same approach as the SCR, withperhaps a slightly dierent calibration and/or riskproile to relect the internal risk appetite. Theremay also be scope to include greater inluencerom business strategy and management actionswithin the ORSA compared to the SCR.

Every irm has to conduct its own risk and solvency assessment(ORSA), based on its risk proile, risk appetite and businessstrategy. The results are submitted to the supervisor as part othe supervisory review process.

Key Points

Each irm submits an assessment o itsown solvency needs to the supervisor

The ORSA is an internal risk assessmentprocess as well as a supervisory tool

The internal risk assessment shouldbe part o the business strategy

Firms will need to highlight assumptiondierences between the ORSA and SCR

The ORSA appears to be ormalising what isconsidered to be best practice in the industrytoday. It will ensure consistency between modelsused or internal management and or regulatoryreporting. Firms who do this well should be ableto gain competitive advantage by making moreinormed business decisions understandingthe impact on the risk and capital o the irm.


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Actuarial Function

Firms are required to establish a strong actuarial unction toensure a robust calculation o technical provisions, and alsoto opine on the overall underwriting policy and adequacy oreinsurance arrangements. Actuaries should also be involved withthe risk modelling underlying the SCR calculation and the ORSA,and contribute more generally to the implementation o the irmsrisk management system.

In our view this presents an opportunity or actuariesto spread their inluence in a irm beyond theirtraditional role although it also means that theymay need to expand their skills into new areas.

The Directive allows or outsourcing in irmswhere maintaining an internal actuarial unctionis not costeective or where existing resourcesare already stretched. Outsourcing may alsointroduce additional skills and an independentview, but would be subject to regulatory scrutiny.

Key Points

Firms shall have an actuarialunction in the business

The actuarial unction will oversee thetechnical calculations, ensuring the useo appropriate methodologies and data


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This report should cover:

the business and its perormanceand governance system

a description o risk exposure, concentration,mitigation and sensitivity by risk category

the bases and methods o valuation orassets and technical provisions, includingany signiicant dierences between thoseused or valuations in inancial statements

details o the capital management, including(amongst others) the MCR and SCR andinormation on the main dierences between thestandard ormula and any internal model used

Some o this inormation may already be in the irmsreport and accounts or other statutory publications.Supervisors will allow irms to avoid disclosingconidential inormation relating to competitiveadvantage, policyholders or other counterparties.

Firms with an existing sound risk management

and perormance measurement ramework will bealready producing much o this material internallytoday. However, additional checks and balancesmay be required to ensure that the published detailsare accurate. Currently the level o disclosure orthis type o material among EU irms is highlyvariable and the Directive will enorce a minimumstandard. This is welcome as it will lead to greatertransparency or policyholders as well as investors,intermediaries and other interested third parties.

New Solvency and Financial

Condition ReportAs part o the public disclosure requirement under Solvency II(Pillar 3) irms will be required to publish an annual report onsolvency and inancial condition.

Key Points

Firms will report annually on theirsolvency and inancial condition

Disclosure may be through aspeciic report or within existingregulatory publications

The report will cover the risk proileand the assumptions underlyingthe technical provisions

Conidentiality o competitiveand policyholder inormationwill be respected


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Technical provisions will be calculated in a prudent,reliable and objective manner, and they will be equal tothe bestestimate, plus a risk margin, unless they canbe replicated using inancial instruments or which amarket value is directly observable. The bestestimateis deined as the mean o the present value o cashlows using the relevant riskree interest rate termstructure. The risk margin shall be determined usinga costocapital approach, and is deined as the costo providing unds equal to the SCR to support theruno o the liabilities. The costocapital rate will

be ixed or all irms, but has yet to be determined.

Valuation o Assets and Liabilities

The Directive states that both assets and liabilities should bevalued at the level at which they could be transerred to aknowledgeable willing party in an arms length transaction.

When calculating technical provisions, the businessshould be segmented into homogeneous risk groups,and, as a minimum, by line o business. Gross andreinsurance amounts should be calculated separately,with the reinsurance reduced to allow or theexpected deault.


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Although the MCR must always be covered locally,the SCR can be calculated at the grouplevel sothat groups beneit rom a streamlined regulatoryprocess as well as diversiication. Initial reactionsrom the market suggest that this may lead to anincrease in merger and acquisition activity.

The group needs to demonstrate that it has suficientunds to cover its SCR across the Community andthat there is no practical or legal restriction on theprompt transer o the unds to support irms within

the group. In this way the subsidiaries within a groupcan cover their SCR, over and above their own unds.The group supervisor will review, at least annually,any signiicant risk concentration at the level o thegroup and any signiicant intragroup transactions.

The grouplevel SCR may be calculated using eitherthe standard ormula or an approved internal model.The approval criteria or an internal model are thesame as or any individual irm. However, the varioussupervisors involved will need to agree a joint view.I the supervisor o a subsidiary irm doubts thatthe group model properly captures its risk proile,

they will have the power to impose capital addons to the individual irm, or insist that its SCR iscalculated using the standard ormula instead.

Most o the other requirements or an individualirm will also apply or the group. Risk management,internal control systems and reporting proceduresshould be implemented consistently throughout thegroup, so that they can be controlled at the group level.

Firms must produce a report on the solvency andinancial condition at the group level. Subject to theagreement o the group supervisor, a group may

provide a single report providing the inormationor each subsidiary and the whole group.

Group Supervision

For each group operating across multiple territories, a singleauthority will be appointed or coordination and decisionmaking the group supervisor.

Key Points

Groups will be supervisedcentrally in cooperation with therelevant territorial regulators

Although the MCR must be coveredlocally, the SCR can be calculatedat the group level, provided thatunds can be transerred aroundthe group to support the SCR

The grouplevel SCR can becalculated using the standardormula or an internal model

The annual solvency and inancialcondition report may be produced at thegroup level with inormation coveringboth the group and subsidiaries


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Whilst the Directive states that regulation shouldalways be proportionate to the nature o the irm,it is likely to drive consolidation within Europeas larger companies gain signiicant beneitsin diversiication, skills, group supervision andcapital lexibility. Monoline companies may indthemselves at a disadvantage and consumers maydiscover that they have less choice i the marketbecomes dominated by a ew large players.

The act that the deadline or Solvency II has

been extended by 2 years underlines the scaleo the implementation challenge. AlthoughBasel II demonstrates that such harmonisation ispossible, it has also shown the enormous cost andeort involved, and this must have an impact onpremiums. The EU is now bigger than when BaselII came into play with dierent countries at verydierent points with regard to capital regulation.

To be ready in time, irms, whatever their size,must start the planning now, in particulardeining their risk management strategies andevaluating the ways to calculate capital.

But Solvency II is not just about meeting regulatoryrequirements. Ultimately, the winners in Europe will bethose companies who take the opportunity to reallyembed the principles into their corporate culture andensure it becomes a better way o doing business.

Conclusion

Solvency II has the potential to bring huge improvements tothe European insurance industry. It will level the playing ieldby ensuring consistent regulation in all territories. It shouldalso improve the solvency o the industry and that meansbetter protection or consumers. It promises beneits o bettercapital management by aligning solvency with the risk proile oeach irm. Much work has been done to balance protection orpolicyholders with competitiveness or companies.


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Ask the Experts

The NetherlandsBart Kling,Managing DirectorContact: +31 (0)20 820 00 [email protected]

Norwayrjan dland,Managing DirectorContact: +47 93 00 88 [email protected]

FranceStphane Chappellier,Managing DirectorContact: +33 (0)1 4268 [email protected]

GermanyFrank Sommereld,Managing DirectorContact: +49 (0) 221 356 626 [email protected]

Mike Wilkinson,Business [email protected]

Andrzej Czernuszewicz,[email protected]

Richard Millns,[email protected]

UK

GermanyKnut Schaeer,Managing DirectorContact: +49 (0) 221 356 626 [email protected]


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For more inormation contact your local EMB ofice or email us at [email protected].

The inormation and opinions contained in this publication are or general inormation purposes only. They do not constitute deinitive proessional advice,and should not be relied on or treated as a substitute or speciic advice relevant to particular circumstances. EMB does not accept or assume any liability,responsibility or duty o care or any loss which may arise rom reliance on inormation or opinions published in this publication or or any decision basedon it. EMB would be pleased to advise on how to apply the principles set out in this publication to your speciic circumstances. Copyright 2009-2010. EMBConsultancy LLP All rights reserved EMB reers to the international actuarial consulting and sotware practice carried on by EMB Consultancy LLP EMB

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Japan,Tokyo+81 3 5942 [email protected]

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Australia,Sydney(The Quantium Group)+61 2 9292 [email protected]

EuropeUnited KingdomEpsomCambridgeLondon+44 (0)1372 [email protected]

Germany,Cologne+49 221 [email protected]

France,Paris+33 (0)1 78 94 21 [email protected]

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