October 27th, 2011

Solvency II Pillar One: Capital Requirements

Posted at 1:00 AM ET

The first pillar of Solvency II is the quantitative component of the new regulations. It deals with the capital requirements of insurers wishing to provide coverage in the EC markets.

Solvency Capital Requirements and Minimum Capital Requirements

Solvency II contains two levels of capital requirements: the Solvency Capital Requirement (SCR) and the Minimum Capital Requirement (MCR). The SCR is a target level of capital, while the MCR is a minimum threshold below which companies will no longer be permitted to trade. If the available capital lies between the SCR and MCR, it provides an early indicator to the supervisor and insurance company that action needs to be taken.

SCR can be determined through a partial or full internal model, or by using Solvency II’s standard formula. As discussed earlier, a critical decision facing (re)insurers is whether to develop their own internal capital model or use the standard formula supplied by regulators.

Resources Are a Major Factor

Greater pressure in preparing for Solvency II falls on companies that may be smaller, less diversified and with more limited resources. IT support, for example, may not be available to all companies who need to demonstrate sufficient data quality in the process of obtaining regulatory approval for their internal models. These companies may also have lower levels of diversification and potentially more volatile or insufficient data to develop and use internal models. This may be exacerbated for companies like mutuals without easy access to additional capital.

Implementation Issues Differ By Insurer Category

Solvency II’s impact and implementation process depends on the size, sophistication and business mix/level of diversification of a given company. There are three classes of insurers that may encounter different experiences in the implementation and the impact of Solvency II: niche, small to mid-size and large global players.

Niche - Niche insurers may be monolines or less diversified in terms of lines of business or geographic coverage. For these companies, the standard formula may be quite punitive, creating an incentive - or even an absolute need - to put in place a partial or full internal model. Depending on their sizes, they may also have lower levels of resource availability to address Solvency II, further complicating the situation.

Companies that do not implement an internal model are expected to face higher capital charges. They may need to take steps to mitigate these requirements. They can opt to bring in additional capital (at a cost) or strategically divest certain lines of business through the purchase of reinsurance protection. These options may include loss portfolio transfers, adverse development covers or other types of run-off protections. They can also choose to enter new lines of business in order to diversify their writings and consequently, achieve lower marginal capital requirements.

Small to Mid-Size (revenues below EUR5 billion) - While some mid-size companies are already seeking approval for internal models, many smaller players are expected to use the standard formula for the short term and will later begin a concurrent implementation of their own internal models. Using the standard formula spreadsheet, the calculation of capital requirements can be done fairly quickly without a large resource dedication. Development of an internal model, as discussed, requires a larger resource commitment from both staffing and financial perspectives.

There are other factors that may steer a company away from development of an internal model. For example, Solvency II may be seen as a purely regulatory requirement with no resultant impact on profitability. There may also be uncertainty related to receiving approval of the internal model and the length of time required to receive the approval.

In some instances, it may be beneficial for companies to opt for the standard formula permanently. The risk charges behind the standard formula are by definition meant to be conservative, but this may not turn out to be the case for all companies. In fact, there may be cases where this approach will actually provide lower capital charges than those produced through an internal model. (This overly positive assessment, however, may lead some companies to make inappropriate decisions about risk and capital management, which potentially could create directors and officers liability exposures for these companies.)

Large Global (multiline, reinsurers, revenues over EUR5 billion) - Large, global (re)insurers are typically opting for an internal model approach, and many are already in a pre-application phase with regulators as part of the Internal Model Approval Process (IMAP).

These companies are currently facing Solvency II-related resource burdens, particularly around documentation requirements and transparency of the model. They will also face choices about which facets of the implementation work should be outsourced.

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