Solvency II. Sandra Eriksson Barman Oskar Ålund. November 27, Abstract

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1 Solvency II Sandra Eriksson Barman Oskar Ålund November 27, 2011 Abstract The insurance industry needs to be regulated to protect policyholders. This is the main objective of the Solvency II directive the new insurance regulations for the European Economic Area. In short, it requires insurance companies to act responsibly with the money they have been entrusted with. It is estimated that implementing Solvency II will cost 2-3 billion Euro. It has the potential to change a lot in the way insurance companies operate, and these changes will hopefully benefit not just policyholders but also the insurance companies in the long run. In this report we outline the main points of the directive and the reasoning behind them. The report is mostly a joint effort, with Sandra focusing on the parts about capital requirements and Oskar on the parts about supervision. 1

2 Why do we need insurance regulation? Insurance is an important part of the economy as it is a key part of the transfer of risk in society. By pooling a large number of risks and estimating the total losses of the group, an insurer transfers individual risks to the insured group as a whole. This is useful for individuals as well as businesses, and in extension for the whole economy. For businesses investing in a new and risky area, insurance can play a pivotal role. In essence, any risk that can be quantified, that is any risk that can be measured with a number, can be insured. The insurance industry in Europe generates over 1.1 trillion Euro in premium income per year, and invests over 6.8 trillion Euro in the European market ([1], p33). Compare this to the Swedish GDP which was estimated at 0.36 trillion Euro in [2] Considering the nature of the insurance industry, it is not surprising that there is a need for regulations. It is very important that the holder of an insurance-policy is protected against unfair treatment and insurance insolvency. This is also stated in Solvency II: The main objective of insurance [...] regulation and supervision is the adequate protection of policyholders and beneficiaries. [...] Financial stability and fair and stable markets are other objectives [...] which should also be taken into account but should not undermine the main objective. ([3], p3) Insurance companies make money in mainly two ways: through premiums paid by the policyholders and through returns from investing those premiums. Since the premiums are paid in advance of any eventual service from the insurer, this leaves the policyholders in a very vulnerable position. The insurance industry is a prime target for fraud because of this fact which also makes the industry easy to enter, and regulations can be easy to manipulate. ([1], p33) Even a company with good intentions without sufficient skills in risk estimation, corporate governance and investment strategies can undermine policyholder rights. Examples of this are firms that expand too fast and don t have enough experience to understand the risks of the new market, or companies that underprice their insurance-policies to get an advantage over their competitors. What is Solvency II? Solvency II is a new insurance regulation for the 27 countries in the European Economic Area (in addition to EU this includes Norway, Iceland and Liechtenstein). The Solvency II directive will replace 14 existing EU-directives on insurance effective today ([1], p72). The implementation date of the regulations for insurance companies is estimated to be 1 January [4] Solvency II is a rather big step from the existing regulations, and it is expected to have a large impact on the insurance industry in Europe. It will also have effects on insurance companies in other parts of the world, since every insurance company operating in Europe will have to comply with the regulations, even those based in other regions. It is estimated that there are over 5000 insurance companies operating in Europe ([1], p9). The Solvency II directive will apply to all insurance companies with annual gross premium income over 5 million Euro. There are also other criteria a company can satisfy that will make the directive applicable [5]. In October 2007 the European Commission Solvency II Assessment estimated that the initial cost of implementing Solvency II for the whole EU insurance industry will be 2-3 billion Euro ([1], p86). The idea is that insurance companies will benefit in the long run from implementing the directive. Solvency II comprises three pillars of different nature. The first pillar is mainly concerned with how to calculate a solvency capital requirement, SCR, which represents the least sufficient capital 2

3 that an insurer must possess in order to properly protect its policyholders. The second pillar is concerned with qualitative requirements the insurer must satisfy. The third pillar guarantees that the insurer operates under some sufficient level of transparency. Insurers will be able to choose between following a standard model and implementing an internal model. This structure mimics Basel II, the current regulations for banks. Basel II also consists of three pillars and banks have the opportunity to implement an internal model if they wish. An important difference between the two is that Solvency II aims at a principles-based regulation of the insurance industry, so as to avoid what many consider has been a great pitfall of Basel II that it incentivized business strategies designed to circumvent the rules. The risks facing an insurance company To better understand the Solvency II directive it is good to know a little bit about the different risks an insurance company faces. There are many different kinds of insurance, and consequently many different kinds of insurance companies. The specific risks facing an insurance company will be very important in the application of Solvency II to that company. Solvency II categorizes these risks mainly into these different types: Underwriting risk: life, health and non-life risk Market risk Credit/default risk Operational risk Liquidity risk Underwriting risk is the risk that the payments an insurer has to make to its policyholders the claims payments are greater than expected. Underwriting risk will vary greatly between different lines of insurance businesses, with risks stemming from low-frequency/high-severity events such as earthquakes or terrorist attacks, to risks stemming from high-frequency/low-severity events such as car-accidents. Underwriting risk is divided into three main categories in Solvency II: life, nonlife and health risk. Life risk concerns insurance that is contingent on the life of an individual. Examples are private pensions and life insurances. Health risk concerns insurance contingent on the health of an individual. Non-life risk could concern anything from fire and home-insurance to financial and liability insurance. Life and non-life insurance often differ quite a lot with respect to the underlying risks and the time-range of the insurance contracts and will therefore need to be treated rather differently. Health risk will be similar to life or non-life risk, depending on the type of health insurance. Market risk which can be construed as the risk that market values, such as the interest rate, differ from their expected values is an important risk factor for insurers. It is often considered to be the most important risk factor for life insurers, because of the often very long duration of life insurance contracts. Credit risk is the risk that a counterparty of a financial agreement will not honour their part of the contract. Operational risk is defined for insurers as the risk stemming from failed internal processes, people, systems or external events ([1], p27). Good operational risk management is in essence good management. Liquidity risk for insurers is the risk that an insurer cannot sell an asset without losing some of the value of the asset. This could be a problem if there is the equivalent of a bank run for a life insurer, i.e. a lot of people want to terminate their contracts and get their deposits back at the same time, or if there are a lot of claims in a short period. Liquidity risk is the only risk listed above that will not require a capital buffer in Solvency II since it is essentially a cash-flow risk. Insurers will instead be required to manage this risk in other ways. 3

4 Capital requirements of Solvency II Solvency Capital Requirement (SCR) The capital an insurer is required to hold as a safety buffer the solvency capital requirement (SCR) will depend greatly on the company s risk profile. All of the risk types listed above, except liquidity risk, will require that the insurer holds capital as a safety and the amount of capital required will be calculated in different ways depending on the risk type. The final solvency capital requirement will be a weighted sum of the capital requirements for each individual risk. The SCR for an insurance company will correspond to a yearly 99.5% value at risk (VaR), i.e. it will be the amount of capital the insurer will need to hold to cover its expenses so that the risk of bankruptcy over one year is one-in-two hundred. In Solvency II the modules life risk, health risk, non-life risk, and market risk are divided into submodules and a capital requirement is calculated for each sub-module, corresponding to a yearly 99.5% VaR for that sub-module: Life risk Health risk Non-life risk Market risk Mortality Long-term Premium and reserve Property Longevity Short-term Catastrophe Interest rate Disability Worker s compensation Equity Expense Spread Lapse Concentration Catastrophe Revision Default risk and operational risk do not have any sub-modules and the capital requirements for these are calculated directly for the modules themselves. The required capital for the interest rate sub-module is for example calculated using two stress scenarios. When calculating the life, non-life and health risk sub-modules, spreading risks through different lines of insurance businesses will be rewarded. Some of the risk (sub-)modules will be highly correlated, while others will be totally independent. It is important to recognize the way the risks an insurer faces are related when calculating the SCR. This will be done by first multiplying the capital of the different sub-modules in pairs, weighted by a correlation coefficients corresponding to the pairs, and then taking the square-root of the sum of these to get the capital requirement for the module itself. The same procedure is then used to get the final SCR from the modules. [3][6] Insurers following the standard model will be supplied a matrix with these correlation coefficients. The correlations between different risks have been adjusted to the insurance industry as a whole. They have been tested on a large part of the European insurance market and adjusted according to the feedback. The correlations will be updated as for example mortality rates or inflation rates changes [6]. As an example, it is clear that the risks of life insurance and private pensions are correlated. A large rise in life insurance claims due to some catastrophe could significantly reduce the amount of pensions owed. Therefore the risks of life insurance can to some extent offset the risks of private pensions. This relationship between life insurance and pensions will be reflected in the correlation between the longevity and mortality sub-modules of life risk, which in the standard model is suggested to be ([6], p33). Insurers will also have the option of implementing an internal model, where among other things they will be able to estimate their own correlation coefficients. The coefficients might then better reflect the conditions in their particular market, which may result in a lower SCR. The SCR will in addition to being risk-sensitive also take into account so called risk-mitigation techniques, where the insurer transfers parts of their risks somehow. This is often done through reinsurance, which is insurance for insurance companies. It is also rather common to use derivatives 4

5 to hedge some of the market risks. Minimum Capital Requirement (MCR) There is in addition to the SCR another capital requirement the minimum capital requirement (MCR). It will correspond to an approximate yearly 85% VaR, in contrast to the SCR which corresponds to a 99.5% VaR over one year. That means that there is a 1/6 change that the MCR does not protect against bankruptcy over the next year. The MCR is supposed to be between 25% and 45% of the SCR. ([3], p60) The way the MCR is calculated is pretty similar to the way the capital requirements are calculated today under Solvency I. It will not be a risk-based capital requirement, as the SCR is. Instead it will be a simple linear function of some basic variables such as the insurance company s premiums and administrative expenses. The capital requirements in Solvency I have been criticized for being too simplistic and not risk-sensitive. But it is still a good idea to have a simple capital requirement such as the MCR in addition to the more complex SCR as an absolute lowest limit of capital. The consequences of going below the MCR will be much more severe than those of going below the SCR. Supervisory aspects of Solvency II In the following we will often speak of principles as opposed to rules. Let us therefore begin by clarifying the difference between the two. A rule is something very clear, in the sense that it is obvious how and if it is being complied with. A principle, on the other hand, is more general. It need not be obvious if it is being followed; however it is sometimes obvious that it is being broken. Principles can be both more and less restrictive than rules this is an important distinction in the context of Solvency II, as we will see. The ends of a regulatory system grounded in principles are more readily attained than those of a strictly rules-based system. This is because a rules-based system of any significant scope is vulnerable to loopholes that may not only work against the point of the system, but may also promote inefficient and counter-productive business practice. E.g. rules may be designed with policyholder protection in mind, but some odd workaround could allow insurance companies to completely or partially disregard such protection. The issue here is that even if the rules are enforced, the point of the rules may not be. Solvency II attempts to resolve this problem by making the goals or principles of the system more easily enforceable. The belief is that if quality risk-assessment is an integral part of the insurer s business operations, then that will lead to good policyholder protection. But to do business while paying close attention to your risk-profile is too vague to be called a rule, yet that is what needs to be enforced. A recurring theme in Solvency II is continuous insurer supervision not only to guarantee that the insurer is in compliance with the technical rules of the directive, but, just as importantly, to see to it that the company is managed with the risk-based principles of the directive in mind. It is expected that these elements of Solvency II will bring about a general shift in company attitude to one where business decisions are heavily influenced by the company s risk-profile. As previously mentioned, Solvency II is structured around three pillars. These pillars and their supervisory roles are explained below. 5

6 Pillar 1 The MCR and the SCR are the key components of the first pillar. They are to be calculated on a regular basis and reported to the insurer s supervisors. Recall that the SCR and MCR is, according to the model, enough capital to cover highly improbable (0.5% in a year) and somewhat improbable (15% in a year) losses respectively. If an insurer is unable to comply with capital requirements, a supervisor may intervene in a number of ways. Such intervention includes collaboration with the insurer in developing a plan to increase capital, restricting new insurance contracts, or even withdrawal of insurance authorization, depending on the severity of the breach. Pillar 2 The second pillar deals with two important concepts. The Own Risk and Solvency Assessment (ORSA) and the Supervisory Review Process (SRP). Remember that Solvency II is a principlesbased directive. The ORSA is a set of risk-management principles. The insurer is required to develop and employ procedures to (at least) annually assess its solvency needs. Furthermore, the insurer must demonstrate that these assessments play a key role in its overall business strategies. This process is meant to instil a healthy risk-aware and risk-centred business culture. The ORSA procedures should involve stress testing as well as capital and risk projections that should be used in planning for the future. Note also that because the results of the ORSA are to be reported to a supervisor, the ORSA can serve as a basis for regulatory action one of the key points in the Supervisory Review Process. Should ORSA procedures be deemed inadequate, the supervisor may impose additional capital requirements on the insurer. Such regulatory action is one aspect of the SRP. The SRP refers to supervisory review of a number of different areas and possible measures the supervisor can take in case a firm does not live up to certain standards. The reasoning behind the principlesbased structure of the directive becomes apparent in light of this review process. To guarantee policyholder protection, it is essential that we can impose general principles, in addition to rules, on the insurer this is what the SRP is for. Most importantly it allows the supervisor to take action against a poorly risk-managed firm, even though they may not be breaking any specific rules. For example, if the supervisor feels that the standard model does not capture the insurer s risk-profile, they can be ordered to develop an internal model. Pillar 3 The insurer must provide a public annual Solvency and Financial Condition report, containing descriptions of risk exposure, MCR and SCR calculations, information on the main differences between the standard and internal model (if one is used), as well as explanations of methods for valuation of assets. The company must further ensure that the complexity of assets underlying a portfolio is commensurable with ability of personnel and systems. It is possible for the insurer to keep some information private for competitive reasons. These reasons should be outlined in the report. Discussion Implementing complex regulations on a big player in the market such as the insurance industry is a difficult thing to do. It is bound to change the industry, but will the changes be those that were intended? And will the benefits outweigh the costs of implementing the regulations? It is considered that Solvency II will cause insurers to adopt a lower-risk product mix, more 6

7 cautious investment strategy and, for certain products, higher premiums. Since insurance companies are big investors, changes in their investment strategies might have a big impact on the market. Smaller returns on private pensions is another likely effect of the new regulations [7]. But it is impossible to know exactly what will change, and if these changes are good or not. Our opinion is that insurance companies should take advantage of the more advanced mathematical modelling and financial instruments available today in a responsible way, and we think that the new regulations have a good chance of encouraging companies to do so. Because of the focus on good risk management throughout the business, and the new requirements of disclosure to the public, it will probably be more advantageous for a company to implement good risk-management systems in the future than it is today. We also feel that the way the directive is implemented over the next years is crucial to its success. The directive s emphasis on supervision will require both insurance companies and regulatory agencies to hire a lot of highly competent staff something that does not seem entirely unproblematic. Government agencies tend to be not as well funded as corporations, so how will they be able compete for quality employees? And if they cannot, what kind of complications could arise? The whole point of the directive is that insurer standards are judged by an outside source but if this source is inept, then policyholders may still not be sufficiently protected. Reading Guide Where not stated otherwise, we have gotten our material from [1], which is a book that is available electronically at the Gothenburg University library. It gives a comprehensive overview of Solvency II and includes some interesting topics we haven t been able to go into in this report such as requirements on how capital is invested and how to value assets and liabilities. For a shorter introduction, FSA, the financial regulator for the UK, at is a good source. Solvency II is an ongoing project, and for anyone who wants to follow its development we recommend searching for Solvency II at An example of a subject that is worth following is how the directive will apply to groups of insurance companies, which is not entirely clear today. Bibliography [1] Buckham, David; Wahl, Jason; Stuart, Rose, Executive s guide to solvency II, Hoboken: John Wiley & Sons, 2011 [2] [3] The Solvency II Directive [4] FSA, Policy: Europe and UK [5] FSA, Smaller insurers information [6] CEIOPS Advice for L2 Implementing measures on SII: SCR Standard Formula Correlations 7

8 [7] Solvency II and credit ratings 8