December 29th, 2015

Developments in Europe: Solvency II, Part I

Posted at 1:00 AM ET

After a long period of discussion and many delays, the new European insurance regulatory regime, Solvency II, will commence in January 2016. The rules will be compulsory for all insurance and reinsurance companies and groups in the European Economic Area (EEA). The three pillar approach of Solvency II for (i) quantitative capital requirements, (ii) qualitative risk management standards and (iii) reporting specifications, was derived from the international banking sector regulation (Basel II and Basel III). The Solvency II rules were developed over a period of more than 15 years, and there are many reasons for the long delay. Two notable reasons are differing business models from country to country and pressure on long-term guarantee products. With the goal of creating a common regulatory system in Europe there was much political will to find compromises that allowed different insurance business models in the individual countries to fit into Solvency II, without necessitating many product changes. And the ongoing low interest rate environment continues to create enormous pressure on long-term guarantee products in the private pension system of some European countries.

Quantitative Capital Requirements - Pillar 1 of Solvency II

The basis for the solvency capital requirement calculation is the economic balance sheet, with market values on the asset side and best estimate reserves on the liability side. (Re)insurers are required to have adequate capital levels in place to finance a 1-in-200 year event, or in other words the Value-at-Risk (VaR) at the 99.5 percent quantile level.

For non-life businesses we have only seen a few companies that encounter capital constraints when applying the new Solvency II capital requirement principles. Many of these companies are captives and monoline insurers that lack diversification opportunities. Generally, the Solvency II capital requirements have not been a major challenge for the non-life insurance industry. However, there are some exceptions, with specific companies or sectors of the industry more acutely affected. This is true especially in many Continental European countries where the local Generally Accepted Accounting Principles (GAAP) include a prudent reserving principle, resulting in a considerable amount of hidden reserves between local GAAP balance sheet loss reserve values and discounted best estimate reserves. These hidden reserves are part of the available capital under Solvency II, the “Own Funds,” and can be used to cover the risks of a company. In countries with local GAAP principles already near the best estimate, this has led to the use of reinsurance and sub-debt issuances to address emerging capital shortfalls.

For life insurance businesses, the Solvency II capital requirements can be much more challenging. The ongoing low interest rate environment is especially challenging for long-term guarantee products of the private pension system in many countries, depending on the type of guarantee in the products. According to an announcement from the European Systemic Risk Board (ESRB) in late July 2015, Germany, Sweden, Netherlands and Austria will all face severe problems in their life businesses in the near future due to high minimum guarantee rates above 3 percent in saving products.

To calculate the Pillar 1 solvency position, (re)insurers in Europe may use a standard formula approach, provided by the European Insurance and Occupational Pension Authority (EIOPA), or they may develop a full internal model or partial internal model, which will need to be certified by the national regulator. So far, only a few (re)insurers and groups have applied for internal model certification - many of those are large international insurance groups. Most companies will rely on the standard formula approach.

While many companies have developed internal modeling approaches to improve their control and management capabilities, they are currently not willing to enter the certification process with national regulators. One of the major hurdles in this certification process is the extensive documentation requirements for the model description, the validation process and the use test. In some cases the insurance companies have to interpret unclear rules and the internal model results are also vulnerable to last-minute decisions on calibrations. This uncertainty, together with the occasionally limited capital savings opportunities achieved by using an internal model compared to the standard formula, have steered many (re)insurance companies and groups away from entering the certification process. This, of course, may change after Solvency II begins next year when the uncertainty around calibrations and the certification requirements will likely disappear.

Link to Part II>>

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