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What are Solvency I and Solvency II?

May 26, 2011 3:03 PM

Solvency I

The solvency margin is the amount of regulatory capital an insurance undertaking is obliged to hold against unforeseen events. Solvency margin requirements have been in place since the 1970s and it was acknowledged in the third generation Insurance Directives adopted in the 1990's that the EU solvency rules should be reviewed. The Directives required the Commission to conduct a review of the solvency requirements and following this review, a limited reform was agreed by the European Parliament and the Council in 2002. This reform is known as Solvency I.

The idea for EU-wide insurance legislation is to facilitate the development of a Single Market in insurance services, whilst at the same time securing an adequate level of consumer protection. The early Solvency requirements which were introduced in the early 1970s were only a minimum harmonisation directive. Because of this, it allowed for differences to emerge in the way that insurance regulation was applied across Europe leading to different regimes. It was also primarily focused on the prudential standards for insurers and did not include requirements for risk management and governance within firms. Solvency I was only completed in the early 1990's with the third generation Insurance Directives. The third generation Insurance Directives established an "EU passport system" (single licence) for insurers based on the concept of minimum harmonisation and mutual recognition.


Solvency II

The economic and social importance of insurance is such that intervention by public authorities (such as the FSA), in the form of prudential supervision, is generally accepted to be necessary.

Not only do insurers provide protection against future events that may result in a loss, they also channel household savings into the financial markets and into the real economy. Intervention by public authorities has tended to focus on introducing measures that seek to guarantee the solvency (reserve capital an insurance undertaking is obliged to hold against unforeseen events) of insurance firms, or minimise the disruption and loss to the general public caused by insolvency. An example of the need for this regulation is the insolvency of Equitable Life insurance in 2000 and the bailout by the UK Government to its policy holders which was both belated and insufficient.

Solvency II aims to achieve consistency across Europe on the key ideas of:

  • Market consistent balance sheets.
  • Risk-based capital.
  • Own risk and solvency assessment (ORSA).
  • Senior management accountability.
  • Supervisory assessment.

Solvency II will be based on economic principles for the measurement of assets and liabilities. It will also be a risk-based system as risk will be measured on consistent principles and capital requirements will depend directly on this. While the Solvency I Directive was aimed at revising and updating the current EU Solvency regime, Solvency II has a much wider scope.

A solvency capital requirement may have the following purposes:

  • To reduce the risk that an insurer would be unable to meet claims.
  • To reduce the losses suffered by policyholders in the event that a firm is unable to meet all claims fully.
  • To provide early warning to supervisors so that they can intervene promptly if capital falls below the required level.
  • To promote confidence in the financial stability of the insurance sector.

Often called "Basel for insurers," Solvency II is somewhat similar to the banking regulations of Basel II. For example, the proposed Solvency II framework has three main areas (pillars):

  • Pillar 1 consists of the quantitative requirements (for example, the amount of capital an insurer should hold).
  • Pillar 2 sets out requirements for the governance and risk management of insurers, as well as for the effective supervision of insurers.
  • Pillar 3 focuses on disclosure and transparency requirements.

What Sharon has done

When Solvency II was first discussed in Sharon's ECON committee, Sharon insisted on a way to be able to amend how different events and assets inter-relate instead of having fixed estimates in the legislation which were clearly inaccurate. Eventually the actuaries all agreed Sharon was right, and Sharon's amendments are now recognised as essential to dealing with catastrophe planning amongst other things.

Sharon said this before the financial crisis in 2008, which subsequently showed that correlation factors in insurance was one of the things that was wrong in banking and recognised as fuelling the crisis. Indeed Sharon complained that there were issues with the amount of capital banks had also (capital requirements), however Sharon arrived too late in European Parliament to fix it there.

Sharon is still working on the intricacies of Solvency II and is changing some of the fixed estimates that still remain in correlation factor legislation. These changes are predominantly in deposit guarantee schemes so that mutual insurance companies (companies owned solely by its policy holder and not shareholders) do not get treated wrongly.

If you would like to read more about Solvency I and II please click here:

http://ec.europa.eu/internal_market/insurance/docs/solvency/impactassess/executive-summary_en.pdf

If you would like to read more about Solvency I and II from a UK perspective please click here:

http://www.fsa.gov.uk/Pages/About/What/International/solvency/index.shtml