Overview on Solvency II in a Layman Language - Phase 1

Wed Jul 19, 2023

Basic 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.

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 me give you further information i.e. breakdown of asset classe

Now tell me, 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.

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.

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

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.

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 

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 risk management and 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.

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 I am trying to say that 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!!

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Kamal Sardana
Qualified life Actuary.

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