Overview on Solvency II in a Layman Language - Phase 1 - Actuarial
Overview
Solvency II
is set of rules set by regulatory body that tells insurance company regarding
how much capital should they hold.
Let’s
understand with the help of an example…
Suppose
there are 2 insurance companies i.e. Company X and Company Y
Company X |
Company Y |
||
Assets |
100 million |
Assets |
100 million |
Liability |
80 million |
Liability |
80 million |
On the basis
of only this information, what do you think, which company is financially
strong ? which company is performing better ?
Your answer would be that both these companies have same level of security.
Now let us give you further information i.e. breakdown of asset classes
Company X – Assets |
Company Y – Assets |
||
Equities |
80 million |
Govt. Bonds |
80 million |
Derivatives |
20 million |
Corporate Bonds-AAA credit rating |
20 million |
Now tell us,
which company is less risky ? which company has more likelihood of not making default
on there obligation i.e. payment to policyholders….
Obviously
company X is more risky than company Y. That’s why the concept of Risk Based
Capital regime comes into existence which states that
The more risky
the company is, the more will be the capital requirement.
Now question
is what is capital requirement ?
Capital
requirement is the amount of capital that a company has to hold to ensure that
they have sufficient assets available to pay off their liabilities whenever
they due within a given time frame with a given degree of confidence.
𝐒𝐮𝐛𝐬𝐜𝐫𝐢𝐛𝐞 𝐭𝐨 𝐦𝐲 𝐘𝐨𝐮𝐓𝐮𝐛𝐞 𝐂𝐡𝐚𝐧𝐧𝐞𝐥 𝐭𝐨 𝐥𝐞𝐚𝐫𝐧 𝐏𝐲𝐭𝐡𝐨𝐧 𝐚𝐧𝐝 𝐒𝐐𝐋 𝐟𝐨𝐫 𝐀𝐜𝐭𝐮𝐚𝐫𝐢𝐞𝐬
Definition
of Solvency II
·
It
is the rules governing how insurers are
funded and governed. Here, insurers will need enough capital to have 99.5
percent confidence they could cope with the worst expected losses over a year.
The rules take a risk-based approach to regulation: the riskier an insurer’s
business, the more precautions it is required to take (i.e. more will be the
capital requirement)
·
It
applied to insurers based in European Union and UK as well
·
All
EU insurance and reinsurance companies with gross premium income exceeding €5
million or gross technical provisions in excess of €25 million (Now question
is what is Technical provisions ?? we will discuss it in the end)
·
Regulator
is PRA i.e. Prudential Regulatory authority but supervision is being done by
EIOPA i.e. The European and Occupational Pensions Authority, which is the EU’s
insurance regulator.
Three
Pillars of Solvency II
Solvency II
is based on 3 pillars i.e.
Pillar
1: Quantitative requirements
·
It
covers the concept that how can we quantify the risk into the capital
requirement that company should hold.
·
It
sets the two distinct capital requirements i.e. SCR and MCR
o
SCR:
Solvency Capital requirement is the amount of capital that company should hold
as prescribed by regulatory basis (i.e. methods and assumptions). If company
does not hold SCR then regulator will intervene in insurance company business and
try to reduce the risk within the business such as:
§ Asset liability matching
§ Investment in less risky assets
§ No bonus distribution
§ Increase in reinsurance
o
MCR:
Minimum capital requirement. If company does not hold even MCR level of
capital, then insurance company license may get cancel to sold new business
Pillar
2: Qualitative requirements
·
It
focuses on
o
Risk
management
o
Governance
·
Insurers
are required to carry out an Own Risk and Solvency Assessment (ORSA)- The Economic
capital model is a key element of the ORSA process, and this is required to be
reviewed by the supervisor.
Pillar
3: Reporting and Public disclosures
·
It
comprises of disclosures and reporting regime. Reports to public and regulators
are required to be made.
In our next
article we will discuss each and every component of this balance sheet in
detail and in a simple and layman language.
But let’s
see one good example based on this balance sheet.
Suppose
Assets = 100, Liabilities i.e. Technical provisions = 60
Then Own
Funds or NAV i.e. Net Assets Value = 100 - 60 = 40 million
Now Let’s
say SCR = 15 and MCR is 5 million
Then
Surplus or Excess Assets = Own Funds – SCR = 40 -15 = 25 million
So that is
what we are trying to say if my NAV (or OF i.e. Own funds) is less than 15
million (i.e. SCR) then regulator will intervene and if my NAV is less than 5
million (i.e. MCR) then insurance company will not be allowed to sell new business!!!!
𝐒𝐮𝐛𝐬𝐜𝐫𝐢𝐛𝐞 𝐭𝐨 𝐦𝐲 𝐘𝐨𝐮𝐓𝐮𝐛𝐞 𝐂𝐡𝐚𝐧𝐧𝐞𝐥 𝐭𝐨 𝐥𝐞𝐚𝐫𝐧 𝐏𝐲𝐭𝐡𝐨𝐧 𝐚𝐧𝐝 𝐒𝐐𝐋 𝐟𝐨𝐫 𝐀𝐜𝐭𝐮𝐚𝐫𝐢𝐞𝐬
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We hope that
you enjoyed this article, we are creating a series of articles on Solvency II.
Stay Tuned
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