The European Union Solvency II Directive, often referred to simply as Solvency II, is a fundamental reform of the capital adequacy and risk management regime for European insurance companies. Its predecessor, Solvency I, was implemented in 2002, but did not radically alter requirements that had been in place since the 1970s and it soon became clear that a more comprehensive review was required.
Solvency II is, indeed, comprehensive insofar as it applies to all insurance companies in the European Union (EU) with gross premium over €5 million or gross technical provisions over €25 million; it covers over 30 countries and involves not only the calculation of capital reserves, but also risk management and responsibility for risk right down to employee level. So, while some companies may already be well positioned to accommodate the changes they may still need to alter their operational practices and their risk management strategy, in particular, to a greater degree than they may anticipate.
In the wake of the global financial crisis, Solvency II is intended to promote confidence in the financial stability of the insurance sector. Based on consistent principles for measuring liabilities, assets and risk, Solvency II should reduce the likelihood of insurance companies failing completely and consumer losses or market disruption in the event that they cannot settle claims in full. Furthermore, it will also provide an early warning system, whereby companies can react quickly if capital falls below the prescribed level.
The Solvency II framework describes three tiers, or pillars. The first pillar deals with capital requirements, the second with governance, risk management and supervision issues and the third with disclosure and transparency. Capital requirements will have the biggest impact and will consist of a so-called Minimum Capital Requirement (MCR), below which major supervisory action will be triggered and a Solvency Capital Requirement (SCR), below which some intervention will be triggered, but at a lower level. As far as risk management is concerned, the principle of proportionality, which means less complex risk situations, will apply throughout Solvency II. Firms adopting poor risk management practices will be penalised, but by the same token those adopting good risk management practices will be rewarded.
Solvency II was originally scheduled to be introduced on 31st October, 2012, but its introduction was recently moved back two months to December 31st, 2010, to align the new regulatory framework to the financial year of most European insurance companies. The EU commissioner for financial services, Michel Barnier, has also been keen to play down fears that the new regulations will force most insurance companies to raise money from their shareholders.
Non-compliance with Solvency II could potentially prevent an insurance company from trading legally, so the onus is on IT managers to make sure that IT architectures are ready for the new regulations. The Financial Services Authority (FSA) required companies to state, as early as March 2009, whether they planned to apply for approval of their internal model, with a set programme of dry-runs scheduled for 2010, 2011 and 2012, prior to a final review and approval process.
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