Strategic decisions in solvency ii for the insurance industry of European Union

The Directive 2009/138/EC of the European Parliament and of the Council on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II) was approved on 25 November 2009 and shortly is called Solvency II. Charlie McCreevy, Commissioner of EU Internal Market and Services about Solvency II mentioned: “It is an ambitious proposal that will completely overhaul the way we ensure the financial soundness of our insurers. We are setting a worldleading standard that requires insurers to focus on managing all the risks they face and enables them to operate much more efficiently. It’s good news for consumers, for the insurance industry and for the EU economy as a whole“(Lloyd’s, 2009).

Insurance supervision in the European Union is undergoing significant changes as the Solvency II Directive is going to implement new risk-based capital standards (Eling et al., 2009). Firstly, the risk-based capital was developed by the National Association of Insurance Commissioners of the United States (NAIC, 2007), which is the minimum theoretical amount of capital that an insurance company needs to support its overall business operations. Risk based capital is used to set capital requirements considering size and degree of risk taken by insurer (Pitselis, 2009, 2013). In recent literature an overview of the new Solvency II regime is provided by Eling et al (2007), Doff (2008) and Steffen (2008). They presented various aspects of the EU efforts to develop a harmonized set of insurer solvency regulations. In the context of Solvency II, different aspects of harmonization are discussed in the insurance sector of Lithuania, such as the convergence of Solvency II and future accounting standards (Linartas, Baravykas, 2010) or insurance undertaking‘s risk management (Buškevičiūtė, Leškevičiūtė, 2008). Liebwein (2006) argues for some requirements for Solvency II internal risk models, which is one of Solvency II innovations. A few approaches and aspects of a standard model under Solvency II have been discussed by Sandström (2006), Schubert and Grieÿmann (2007).

Solvency II introduces a new, harmonised EU-wide regulatory regime, which replaces 14 existing insurance Directives. The main objectives of Solvency II are:

• -    better regulation and deeper integration of EU insurance market;

• -    protection of policyholders and competitiveness of EU insurers.

Given that, the main target of new Solvency II system is to ensure the financial soundness of insurance undertakings, and in particular to ensure their survival during difficult periods, protection of policyholders and keeping stability of the financial system as a whole. 2011 year was devoted for adoption of Implementing Measures. The deadline for the transposition of Solvency II Directive into national laws is by the end of June 2013. Now when the experts and supervisory authorities from all EU Member States are working with implementing measures of Solvency II Directive it is very important to familiarize insurance industry and policyholders on the advantages of the new Solvency II regulatory system, to compare it with practice of Basel II implementing measures in banking sector and to analyse the impact of financial crisis.

Firstly, the new Solvency II regime will be based on a more economic riskbased solvency requirements. Now, requirements under Solvency I regime are concentrated mainly on the liabilities side (i.e. insurance risks). Supposed Solvency II requirements will take account of the asset-side risks. Solvency II system will be sufficiently harmonized across all Pillars so that the risks in different locations and companies would be treated consistently (Pikselis, 2009).

Secondly, the new Solvency II system will be a „total balance sheet“ type regime where all the risks and their interactions will be considered. Insurers will be required to identify, measure and proactively manage risks. Depending on this, structure of Solvency II system is based on three-pillar approach, that is similar to Basel II including all the quantitative and qualitative aspects that could affect the solvency situation of the undertaking and giving due attention to governance and risk management issues (CEA, 2010). These main approaches are presented in Table 1 below:

Table 1 . Structure of Solvency II three-pillar system

Pillar 1 Quantitative Requirements -    Balance sheet valuation and capital requirements; - Harmonised standards for the valuation of assets and liabilities; -    Calculation of capital requirements (SCR and MCR), own capital and technical provisions.

Pillar 2 Qualitative requirements Supervisory Review To ensure that insurers have good monitoring and management of risks and adequate capital: -    Internal control; -    Risk management; -    Corporative governance; -    Analysis of scenario; -    Correction of capital.

Pillar 3 Information disclosure Harmonisation of disclosure requirements, allowing capital adequacy to be compared across institutions, focused on supervisory reporting and transparency requirements.

Source: CEA (2010), analysis by author

Table 1 shows that Pillar I requires demonstration of adequate financial resources and is concerned with the asset and liability measurement, including adequacy of technical provisions, and capital requirements. Solvency capital requirements in Pillar I will be based on a market-consistent total balance sheet approach. Solvency II experts have proposed two capital level requirements (CEA, 2007):

• -    a main target level: solvency capital requirement (SCR), which will reflect the economic capital that a company needs to operate safely;

• -    a minimum capital requirement (MCR), which should serve as a trigger level (safety margin) for severe regulation action.

One reason for the introduction of two capital requirements is to establish a better early warning mechanism and thus allow more time for supervisory intervention. The SCR is based on a Value-at-Risk measure calibrated to a 99,5% confidence level over a 1-year time horizon. The SCR covers all risks that an insurer faces (e.g. insurance, market, credit and operational risk) and will take full account of any risk mitigation techniques applied by the insurer (e.g. reinsurance and securitisation). The SCR can be determined either by a standard approach or by an approved (partial) internal model with the standards for approval being achievable by Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS). The standard formula is the method insurers are expected to use to calculate SCR when they do not have their own internal model and therefore should be suitable for calculation by smaller firms. Calculation of the basic Solvency Capital Requirement set out in 2009/138/EC Directive‘s Article 104(1) and shall be equal to the following:

Basic SCR = √ ∑ ij Corr ij x SCR i x SCR j ;

• -    where SCR i denotes the risk module i and SCR j denotes the risk module j, and where „i, j“ means that the sum of the different terms shoould cover all possible combinations of i and j. In the calculation, SCR i and SCR j are replaced by the following:

• -    SCR non-life denotes the non-life underwriting risk module,

• -    SCR life denotes the life underwriting risk module,

• -    SCR health denotes the health underwriting risk module,

• -    SCR market denotes the market risk module,

• -    SCR default denotes the counterparty default risk module,

The factor Corr i,j denotes the item set out in row i and in column j of the following correlation matrix in Table 2:

Table 2. Correlation matric of basic Solvency Capital Requirement (SCR)

i \ j	Market	Default	Life	Health	Non-life
Market	1	| 0,25	0,25	0,25	0,25
Default	0,25	1	0,25	0,25	0,5
Life	0,25	0,25	1	0,25	0,25
Health	0,25	0,25	0,25	1	0
Non-life	0,25	0,5	0	0	1

(Source: Directive 2009/138/EC- Annex IV)

Besides this, there are separate calculations of the non-life underwriting risk module and the life underwriting risk module also. Value-at-Risk (VaR) is a commonly used measure in financial services to assess the risk associated with a portfolio of assets and liabilities. If an insurer's available resources fall below the SCR, then supervisors are required to take action with the aim of restoring the insurer’s finances back into the level of the SCR as soon as possible. If, despite supervisory intervention, the available resources of the insurer fall below the MCR, then „ultimate supervisory action“ will be triggered: the insurer's liabilities will be transferred to another insurer and the license of the insurer will be withdrawn or the insurer will be closed to new business and its in-force business will be liquidated.

Eligible capital is essentially the difference between the capital market consistent value of assets and liabilities. All capital items in the balance sheet have to be assessed on an economic basis consistent with the Solvency II regime. The amount of eligible own funds is derived based on balance sheet basic own funds and the ancillary own funds not on the balance sheet. Capital requirements are calculated based on a comprehensive analysis of risks, taking into account the interaction between assets and liabilities, risk mitigation and diversification.

As own funds items possess different quantities and provide for different levels of absorption of losses, those items will be classified into three tiers depending on their nature and in terms of the extent to which they meet certain criteria.

The value of technical provisions shall be equal to the sum of a best estimate and a risk margin as set out below (Directive, Article 77):

• -    the best estimate shall correspond to the probability-weighted average of future cash-flows, taking account of the time value of money (expected present value of future cash-flows), using the relevant risk-free interest rate term structure;

• -    the calculation of the best estimate shall be based upon up-to-date and credible information and realistic assumptions and be performed using adequate, applicable and relevant actuarial and statistical methods;

• - the cash-flow projection used in the calculation of the best estimate shall take account of all the cash in- and out-flows required to settle the insurance and reinsurance obligations over the lifetime thereof;

• - the best estimate shall be calculated gross, without deduction of the amounts recoverable from reinsurance contracts and special purpose vehicles. Those amounts shall be calculated separately.

The risk margin shall be such as to ensure that the value of the technical provisions is equivalent to the amount that insurance and reinsurance undertakings would be expected to require in order to take over and meet the insurance and reinsurance obligations. Insurance and reinsurance undertakings shall value the best estimate and the risk margin separately. However, where future cash flows associated with insurance or reinsurance obligations can be replicated reliably using financial instruments for which a reliable market value is observable, the value of technical provisions associated with those future cash flows shall be determined on the basis of the market value of those financial instruments. In this case, separate calculations of the best estimate and the risk margin shall not be required.

Where insurance and reinsurance undertakings value the best estimate and the risk margin separately, the risk margin shall be calculated by determining the cost of providing an amount of eligible own funds equal to the Solvency Capital Requirement necessary to support the insurance and reinsurance obligations over the lifetime thereof. The rate used in the determination of the cost of providing that amount of eligible own funds (Cost-of-Capital rate) shall be the same for all insurance and reinsurance undertakings and shall be reviewed periodically.

The Cost-of-Capital rate used shall be equal to the additional rate, above the relevant risk-free interest rate, that an insurance or reinsurance undertaking would incur holding an amount of eligible own funds, equal to the Solvency Capital Requirement necessary to support insurance and reinsurance obligations over the lifetime of those obligations.

Under Solvency II insurance and reinsurance undertakings value assets and liabilities as follows (Directive, Article 75):

• -    assets shall be valued at the amount for which they could be exchanged between knowledgeable willing parties in an arm’s length transaction;

• -    liabilities shall be valued at the amount for which they could be transferred, or settled, between knowledgeable willing parties in an arm’s length transaction. When valuing liabilities no adjustment to take account of the own credit standing of the insurance or reinsurance undertaking shall be made.

Table 1 shows that the Pillar II requirements will include the main principles of internal control and sound risk management for insurance undertaking and will help insurers to have good monitoring of risks and adequate capital. Under Solvency I solvency requirements are based on largely historical data. The new Solvency II rules will require insurers:

• -    to have an effective risk management system implemented by senior management. Risk and capital management must be integrated;

• -    to foresee any future developments, such as new business plans or the possibility of catastrophic events;

• -    the introduction of Own Risk and Solvency Assessment (ORSA);

• -    to introduce the Supervisory Review Process, which will enable supervisors for better and earlier identification of insurers which can have difficulties, to evaluate insurers' compliance with the laws, regulations and administrative provisions.

Under Solvency II Member States shall ensure that the administrative, management or supervisory body of the insurance or reinsurance undertaking has the ultimate responsibility for the compliance, by the undertaking concerned, with the laws, regulations and administrative provisions.

Member States shall require all insurance and reinsurance undertakings to have in place an effective system of governance which provides for sound and prudent management of the business. That system shall at least include an adequate transparent organizational structure with a clear allocation and appropriate segregation of responsibilities and an effective system for ensuring the transmission of information. The system of governance shall be subject to regular internal review. The system of governance shall be proportionate to the nature, scale and complexity of the operations of the insurance or reinsurance undertaking. Insurance and reinsurance undertakings shall have written policies in relation to at least risk management, internal control, internal audit and, where relevant, outsourcing. They shall ensure that those policies are implemented. Those written policies shall be reviewed at least annually. They shall be subject to prior approval by the administrative, management or supervisory body and be adapted in view of any significant change in the system or area concerned.

The supervisory authorities shall have appropriate means, methods and powers for verifying the system of governance of the insurance and reinsurance undertakings and for evaluating emerging risks identified by those undertakings which may affect their financial soundness.

Insurance and reinsurance undertakings shall ensure that all persons who effectively run the undertaking or have other key functions at all times fulfill the following requirements:

• -    their professional qualifications, knowledge and experience are adequate to enable sound and prudent management (fit);

• -    they are of good repute and integrity (proper).

Insurance and reinsurance undertakings shall notify the supervisory authority of any changes to the identity of the persons who effectively run the undertaking or are responsible for other key functions, along with all information needed to assess whether any new persons appointed to manage the undertaking are fit and proper.

Where a Member State requires of its own nationals proof of good repute, proof of no previous bankruptcy, or both, that Member State shall accept as sufficient evidence in respect of nationals of other Member States the production of an extract from the judicial record or, failing this, of an equivalent document issued by a competent judicial or administrative authority in the home Member State or the Member State from which the foreign national comes showing that those requirements have been met.

Solvency II also sets out some new strengthened governance requirements, concerning the management of assets that should further improve practice in this area. The governance requirements for insurers mean that they will have to establish functions responsible to deal with risk management, risk modelling (for internal model users), compliance, internal audit and actuarial issues. These functions must help insurers in their practical implementation of the new rules. Insurers must have an adequate and transparent governance system with a clear allocation of responsibilities and effective reporting lines. Solvency II identifies several functions, such as the risk management function and the actuarial function, which insurers must have.

Other requirements relate to internal control and internal audit, the need to carry out a self assessment of the company's risk and solvency position and the need for board members and senior management to be „fit and proper“.

The requirements concerning governance and risk management must be proportionate to the nature, scale and complexity of the insurer. The review of the governance arrangements and risk management capabilities will form a central part of the supervisory review process. Insurance and reinsurance undertakings shall have in place an effective risk management system comprising strategies, processes and reporting procedures necessary to identify, measure, monitor, manage and report, on a continuous basis the risks, at an individual and at an aggregated level, to which they are or could be exposed, and their interdependencies. The risk-management system shall cover the risks to be included in the calculation of the Solvency Capital Requirement as well as the risks which are not or not fully included in the calculation thereof.

The risk-management system shall cover at least the following areas:

• -    underwriting and reserving;

• -    asset–liability management;

• -    investment, in particular derivatives and similar commitments;

• -    liquidity and concentration risk management;

• -    operational risk management;

• -    reinsurance and other risk-mitigation techniques.

Insurance and reinsurance undertakings shall provide for a risk-management function which shall be structured in such a way as to facilitate the implementation of the risk-management system. For insurance and reinsurance undertakings using a partial or full internal the risk-management function shall cover the following additional tasks:

• -    to design and implement the internal model;

• -    to test and validate the internal model;

• -    to document the internal model and any subsequent changes made to it;

• -    to analyze the performance of the internal model and to produce summary reports thereof;

• -    to inform the administrative, management or supervisory body about the performance of the internal model, suggesting areas needing improvement, and up-dating that body on the status of efforts to improve previously identified weaknesses.

As part of its risk-management system every insurance undertaking and reinsurance undertaking shall conduct its own risk and solvency assessment. That assessment shall include at least the following:

• -    the overall solvency needs taking into account the specific risk profile, approved risk tolerance limits and the business strategy of the undertaking;

• -    the compliance, on a continuous basis, with the capital requirements and with the requirements regarding technical provisions;

• -    the significance with which the risk profile of the undertaking concerned deviates from the assumptions underlying the Solvency Capital Requirement, calculated with the standard formula or with its partial or full internal model.

The own-risk and solvency assessment shall be an integral part of the business strategy and shall be taken into account on an ongoing basis in the strategic decisions of the undertaking.

Insurance and reinsurance undertakings shall have in place an effective internal control system. That system shall at least include administrative and accounting procedures, an internal control framework, the appropriate reporting arrangements at all levels of the undertaking and a compliance function. The compliance function shall include advising the administrative, management or supervisory body on compliance with the laws, regulations and administrative provisions. It shall also include an assessment of the possible impact of any changes in the legal environment on the operations of the undertaking concerned and the identification and assessment of compliance risk.

Insurance and reinsurance undertakings shall provide for an effective internal audit function . The internal audit function shall include an evaluation of the adequacy and effectiveness of the internal control system and other elements of the system of governance. The internal audit function shall be objective and independent from the operational functions. Any findings and recommendations of the internal audit shall be reported to the administrative, management or supervisory body which shall determine what actions are to be taken with respect to each of the internal audit findings and recommendations and shall ensure that those actions are carried out.

Under Solvency I, there is no capital requirement related to market risk. This means that insurers do not have to hold capital against the risk of holding equity investments, or any other volatile or risky financial asset now. Under Solvency II insurers will be required to hold capital against:

• -    market risk (i.e. fall in the value of insurers‘ investments);

• -    credit risk (e.g. when third parties cannot repay their debts);

• -    operational risk.

One of the reasons why it is necessary to consider market risk, or risk associated with investments, is that inappropriate investment strategies or adverse movements in the value of the investments can threaten the financial soundness of an insurer and its ability to meet its commitments. Requiring insurers to hold capital against such adverse scenarios arising out of their investments not only mitigates against insurance failures, but also incentivises insurers to consider the appropriateness of their investment portfolio and the risk associated with it (Pikselis, 2009).

Structure of the market risk module is set out in the 2009/138/EB Directive‘s Article 105(5) and shall be equal to the following:

SCRmarket = √∑Corrij x SCRi x SCRj where SCRi denotes the sub-module i and SCRj denotes the sub-module j, and where "i,j" means that the sum of the different terms should cover all possible combinations of i and j. In the calculation, SCRi and SCRj are replaced by the following:

• -    SCR interest rate denotes the interest rate risk sub-module,

• -    SCR equity denotes the equity risk sub-module,

• -    SCR property denotes the property risk sub-module,

• -    SCR spread denotes the spread risk sub-module,

• -    SCR concentration denotes the market risk concentrations sub-module,

• -    SCR currency denotes the currency risk sub-module.

Under Pillar II, supervisory authorities may extend the recovery period for breaches of the Solvency Capital Requirement in the event of an exceptional fall in financial markets, taking into account all relevant factors.

Pillar III - information disclosure - will require insurers to disclose certain information publicly to a far greater extent than under Solvency I. Pillar III requirements will be closely aligned to the contents of the other two pillars including disclosure and transparency of the Solvency II. Information disclosure will bring in market discipline to support regulatory objectives. Insurers should be prepared to disclose more information publicly than at present. They will be required to give two different types of report:

• -    public, annual Solvency and Financial Condition report;

• -    further information needed for the purposes of supervision

Report on solvency and financial condition contains (Directive, Article 51):

Member States shall require insurance and reinsurance undertakings to disclose publicly, on an annual basis, a report on their solvency and financial condition. That report shall contain the following information, either in full or by way of references to equivalent information, both in nature and scope, disclosed publicly under other legal or regulatory requirements:

• -    a description of the business and the performance of the undertaking;

• -    a description of the system of governance and an assessment of its adequacy for the risk profile of the undertaking;

• -    a description, separately for each category of risk, of the risk exposure, concentration, mitigation and sensitivity;

• -    a description, separately for assets, technical provisions, and other liabilities, of the bases and methods used for their valuation, together with an explanation of any major differences in the bases and methods used for their valuation in financial statements;

• -    a description of the capital management, including at least the following:

• -    the structure and amount of own funds, and their quality;

• -    the amounts of the Solvency Capital Requirement and of the Minimum Capital Requirement;

• -    the option set out in Article 304 of Directive used for the calculation of the Solvency Capital Requirement;

• -    information allowing a proper understanding of the main differences between the underlying assumptions of the standard formula and those of any internal model used by the undertaking for the calculation of its Solvency Capital Requirement;

• -    the amount of any non-compliance with the Minimum Capital Requirement or any significant non-compliance with the Solvency Capital Requirement during the reporting period, even if subsequently resolved, with an explanation of its origin and consequences as well as any remedial measures taken.

Pillar III will help to ensure the soundness and stability of insurers, will force greater cooperation between insurance supervisors and will foster supervisory convergence.

The new Solvency II regime will strengthen the role of the group supervisor who will have specific responsibilities to be exercised in close cooperation with the solo supervisors. Jack de Laruasiere mentioned that the group support regime would:

• -    install colleges of supervisors for cross-border groups and ensure an effective decision making process within the colleges;

• -    allow home based firm to allocate capital throughout the group in an efficient way, subject to safeguard to protect the financial soundness of all the legal entities belonging to the group. This will mean that the same economic riskbased approach will be applied to insurance groups which will be better managed as a single economic entity.

In conclusion , it may be said that this study raises actual problems of Solvency II implementation into national legislation.

• 1.    The new Solvency II regime will be based on more economic risk-based solvency requirements. If requirements under Solvency I regime concentrated mainly on the liabilities side, Solvency II requirements will take account of the asset-side risks and will be sufficiently harmonized across all Pillars so that the risks in different locations and companies would be treated consistently.

• 2.    The main target of new Solvency II system is to ensure the financial soundness of insurance undertakings, and in particular to ensure their survival during difficult periods, protection of policy holders and keeping stability of the financial system as a whole. The European Parliament on March 2014 adopted in plenary session the "Omnibus II" Directive that completes the "Solvency II" Directive and finalises the new framework for insurance regulation and supervision in the EU. The Commission is now preparing the next stage of implementation of Solvency II, which will be the adoption of a Commission Delegated Act containing a large number of detailed implementing rules and also is working on a package of Implementing Technical Standards that will ensure that everything will be ready for the application of Solvency II on 1 January 2016.