Solvency II is an ongoing European initiative to develop an asset risk-focused set of regulatory capital requirements and hold insurers to a higher bar with new capital standards on riskier assets. Its predecessor, Solvency I, was a simple factor-based model. Solvency II has been underway since the adoption of Solvency I back in 2002.
It is slated to become law in October of this year and go into effect, in part, in January of 2013. After January there will be supervisory requirements and undertakings before full implementation comes into force the following year.
Under Solvency II, solvency requirements will also be more comprehensive than in the past, according to the European Commission’s FAQs. Insurers will now be required to hold capital against market risk to protect against a fall in the value of insurers’ investments, credit risk and operational risk (for example, risk of systems breaking down or malpractice).
EU solvency requirements currently concentrate mainly on the liabilities side (i.e. insurance risks).
However, Solvency II will weigh asset-side risks. The new regime will be a ‘total balance sheet’ where all the risks and their interactions are considered, the European Commission states.
Solvency II also emphasizes that capital is not the only or the best way to mitigate against failures.
New rules will for the first time compel insurers specifically to focus on and devote significant resources to the identification, measurement and proactive management of risks.
However, there are a few knots to untie before full implementation.
An NAIC staff paper on financial solvency presented during an NAIC meeting with the Federal Insurance Office (FIO) in December of last year stated: Solvency II is still a few years away from being “operational.”
Specifically, the European Parliament is considering, in closed parliamentary review sessions between now and September, something called Omnibus II, a consideration of certain proposals and tweaks to Solvency II, including relief on certain equivalency standards and the impact of changes to risk-free interest rates for long-duration contracts. A vote has been postponed until the last date that it can be conceivably done.
The Omnibus II proposal also includes the provision for the European Insurance and Occupational Pensions Authority (EIOPA) to provide technical standards between September 2012 and December 2016.
“These [technical] standards are wide ranging, covering areas such as own fund classification, valuations of assets and liabilities as well as capital requirements, supervisory reporting and capital add-ons,” states consultancy Towers Watson on its “Advice for Insurers on the EU Directive” webpage.
This matters because without postponement or relief, an insurer would have to make its entire nondomestic subsidiaries conform to Europe’s Solvency II requirements.
A person in the life insurance industry who is familiar with the topics being discussed noted, “I think Aviva is considering leaving or putting out a trial balloon about leaving because they’re not sure what the European Parliament is going to do with the equivalency.”
And the NAIC shares those concerns. “To the extent that Europe might not find our system of supervision equivalent, it could have negative implications on U.S. insurers doing business in Europe and European insurers doing business in the U.S.,” the NAIC staff paper states.
Solvency II is based on a three pillar approach which is similar to the banking sector (Basel II) but adapted for insurance. Both require high levels of capital for insurers in a way that some say does not fit the insurance industry.
As international regulatory arena veteran Terri Vaughan, PhD, president of the NAIC, described in a policy paper, with a simple factor-based model, the required regulatory capital requirement is a function of premium writings and loss reserves for property/casualty insurance and the sum at risk for life insurance.
“Recognizing the limited risk sensitivity of this approach, particularly its failure to recognize asset risks, it became clear even during the development of Solvency I that a more comprehensive approach was necessary. After several years of work, the European Commission adopted the Solvency II Directive Proposal in July 2007 and amended the proposal in February 2008,” Vaughan explained back in 2009, when implementation was set for 2012.