November 17th, 2009

Group-Level Implications of Solvency II

Posted at 1:00 AM ET

Frank Achtert, Managing Director, and Eddy Vanbeneden, Managing Director

Group support will not be permitted when Solvency II becomes effective in 2012. As a result, the flexibility to use capital held anywhere in the group in calculating the Solvency Capital Requirement (SCR) will not be available. Rather, each entity will have to calculate its SCR based on the capital it has, regardless of its group’s position as a whole. This last-minute change to eliminate group support could prompt some European insurance groups to change their structures - or at least rethink how much risk they will take in each entity.

Under Solvency II, the definition of a “group” is principles-based and thus fairly broad compared to the definition in the Consolidated Accounts Directive. For the purposes of calculating the group SCR, a (re)insurer needs to consider the parts of the group necessary to secure a complete understanding of the group and the entire range of risks it faces. “Significant influence” and “dominant influence” criteria may serve as guidelines for determining the scope of entities to be included; a simple 20 percent/50 percent voting rights definition is not sufficient.

Two approaches are discussed to calculate the SCR for a (re)insurance group: the accounting-consolidation method and the deduction and aggregation method. The former is based on a group’s consolidated accounts (according to International Financial Reporting Standards for listed European companies), with the group solvency margin being the difference between group eligible own funds and the group-level SCR. Using the accounting-consolidation method, the group’s internal transactions are eliminated, including group internal reinsurance contracts. The latter method (deduction and aggregation) compares aggregate individual own funds from the entities within the group to the aggregated individual SCRs. By design, intra-group reinsurance transactions are not eliminated using the aggregation method.

The primary difference between the two methods is diversification. Under the accounting approach, carriers can realize diversification benefits, while the aggregation method constrains this potential. The accounting method was used in Quantitative Impact Study 4 as the default approach, and it is preferred by the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS).

Ultimately, the group solvency assessment needs to be based on the group’s overall capitalization. Excess own funds above an individual entity’s SCR can be used to compensate for shortages in other entities — as long as no legal constraints on the capital exist. Fungibility and transferability will matter, consequently, when considering group eligible own funds.

Complications regarding group support in Solvency II may increase the compliance burden, particularly as European (re)insurers explore structural changes to help them increase the productivity of their capital and the fact that diversification advantages will be minimized. As 2012 approaches, exploring the range of SCR calculation methods, accounting implications and group structures available will help (re)insurers prepare for the implementation of Solvency II. Being ready ahead of the start date translates to immediate advantage, while waiting will come with the substantial penalty of lost time.

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Statements concerning, tax, accounting, legal or regulatory matters should be understood to be general observations based solely on our experience as reinsurance brokers and risk consultants, and may not be relied upon as tax, accounting, legal or regulatory advice which we are not authorized to provide. To the extent that you discuss such statements with your clients, be sure to advise your clients that all such matters should be reviewed with their own qualified advisors in these areas.

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