What is Solvency II?

Solvency II is an EU Directive that aims to harmonise and improve the regulation of all insurance companies in the EU. It applies to life insurance companies, general insurance companies and reinsurance companies.

The primary focus is on ensuring that firms hold an appropriate amount of capital given the risks of their business, and that they manage their businesses in a risk-based manner. By requiring firms to hold an appropriate level of capital, the intention is that consumers should benefit from a reduction in the risk of insurance companies becoming insolvent.

Solvency II came into force on 1^st January 2016 at which point all EU insurance companies have been required to abide by its standards.

Calculating required capital

A key concept of Solvency II is that insurance companies must hold enough spare capital to cover all the material risks they run as a business. Examples of key risks include:

• Market risk: Does the insurer have enough funds if equity markets fall in value by 25% or if interest rates move in a specified adverse manner?
• Lapse or persistency risk: Can the insurer cope financially if significant numbers of policyholders surrender their policies in the next year? Insurers should also look at the effect on capital if lapse numbers decrease as this could also adversely affect the capital required.
• Mortality risk: What would be the impact of increased or reduced mortality experience compared to that used when setting premiums? For term insurance, higher than expected mortality is the problem whereas for other products, notably annuities, the key risk is lower than anticipated mortality.
• Operational risk: Is the insurer exposed to any product mis-selling risks, or risk of fraudulent activities by an employee? Operational risk captures such risks and is defined as a risk of loss occurring from inadequate or failed internal processes, people and systems or external events.

The formulae

The capital requirement is calibrated at a level which aims to ensure it would be sufficient to cover all eventualities with 99.5% confidence. This means that only a ‘1-in-200 years’ scenario would give rise to the possibility of an insurance company not meeting its liabilities. As you may expect, there is considerable uncertainty in how to calculate this for certain types of risks.

There are two distinct approaches firms may use to calculate the capital requirement: the standard formula (which reflects as far as possible a typical European insurance company); alternatively, firms can develop their own internal model which must be signed off by their national regulator.

Larger firms have generally taken on the challenge of developing an internal model to enable better modelling of their individual risk exposures, which may potentially result in lower capital requirements. To gain regulatory approval of an internal model, firms have to meet onerous standards covering many aspects such as statistical quality, validation, how the model is used, documentation, etc. which require significant actuarial input. Smaller firms and those companies with a simpler product ranges are more likely to adopt the standard formula. This could be due to the cost of developing an internal model not being worth the money saved.

Alternatively firms may adopt a partial internal model with some business risks modelled using the standard formula and others using an internal model approach.

What are the changes Solvency II is delivering?

Some of the key changes that the new Directive aims to deliver include:

• Solvency requirements more sensitive to the risks resident within each insurance company.
• A consistent approachto capital requirements across all EU member states.
• Improved risk management, recognising that holding capital is not the sole way to prevent failures from occurring and that insurers must devote resources to the identification, measurement and the proactive management of risks.
• Better engagement between firms and their regulatorsvia the ‘Supervisory Review Process’, which will enable supervisors to identify issues at an earlier stage.
• Increased public disclosure, which should result in more competition.

Solvency II is not just about regulation, but deeply impacts how an insurance business is managed, providing a strong incentive for good management. For example, a consequence of the above points is that a firm managing its key risks well will need to hold less capital than a similar company with poorer risk management, making it more capital-efficient and better for all stakeholders including investors and policyholders.

How does it impact actuaries?

The calculation of capital requirements via internal models is necessitating a deeper understanding of complex stochastic modelling within firms, and this is an area in which actuaries can add significant value. The chance for involvement in such innovative models is likely to be attractive to many graduates considering an actuarial career in insurance.

Because the Insurer’s Board is ultimately responsible for the internal model, actuaries will need to make clear the mechanics behind the model (and its limitations) to the Board. Solvency II therefore provides actuaries with good opportunities to influence at very senior levels.

Solvency II is also about helping companies better understand and manage the risks within a business, covering the entirety of running such a business. Actuaries will therefore need to learn from (and build relationships with) other professionals across the breadth of the business, placing a greater emphasis on communication and business skills than may have been the case in the past.

Solvency II will also drive opportunities for further research giving actuaries the chance to influence and take on key roles in business.

Solvency II’s legacy

It is clear that complying with Solvency II requirements is an ongoing and iterative process and that work does not cease when the Directive is implemented. Insurers will need to be able to accurately capture and model all material aspects of their business to maximise the capital efficiency incentives, which means that companies have an ongoing incentive to refine and improve their models.

Ahead of the Solvency II directive coming in to effect in January 2016, the PRA announced that 19 UK insurers had been given approval to use either an internal model or a partial internal model to calculate their capital requirements. These firms will be required to regularly monitor their internal models and make sure that they continue to meet the PRA’s exacting standards.  Insurers that currently haven’t been given permission to use an internal model may decide to continue trying to implement one. There could also be substantial restructuring within the market as firms move away from more capital intensive products.

As such, we can expect Solvency II to provide interesting and challenging work for new members of the profession for many years to come.
This article was updated by Marc Wiseman at APR LLP in 2016 based on an original draft by Kunal Patel.