SOLVENCY 2An Introduction

ByJohn Brady

12/07/10Don’t forget the risk analysis 1

Solvency 2

To protect the interests of policy holders or beneficiaries by ensuring the financial stability of insurance and reinsurance undertakings within the European Union

04/12/23 2

Solvency 2 (2009/138/EC)

Signed by the Council of European Union

Signed by the European Parliament

Signed on 25th November 2009

Publishd in the Official Journal on the 17th December 2009

Implementation due by 31st October 2012

04/12/23 3

Solvency 2 - Ireland

There are two elements relevant in Ireland The Solvency 2 Directive (2009/138/EC) Financial Regulator - Consultation Paper 41 (CP41)

04/12/23 4

Solvency 2 Pillars

Solvency two is based on three pillars: Pillar One - Adequacy of Financial Resources Pillar Two – Effective Governance Pillar Three – Disclosure Requirements

04/12/23 5

Pillar One

Pillar One sets out the quantitative requirements that undertakings must satify to demonstrate they have sufficient capital resources.

04/12/23 6

Balance Sheet Equation

Free Surplus Assets

Solvency Capital Requirement (SCR)

Minimum Capital Requirement (MCR)

Technical Provision

Other Liabilities

04/12/23 7

Pillar One

Under pillar 1 undertakings must maintain: Technical provisions in respect of all obligations A minimum capital requirement [MCR] A higher solvency capital requirement [SCR]

These requirements must be covered by the undertakings own funds [Regulatory Capital]

04/12/23 8

Technical Provisions

All undertakings must Establish technical provisions with respect to policy holders and

beneficiaries. Value of technical provision should correspond to value of

obligation (if transferred to another undertaking). There are two elements to the technical provision

A best estimate – the best estimate should take account of the time value of money

A risk margin – this is on top of the best estimate and is based on the value if

there is an immediate transfer to another undertaking This is calculated by determining the cost of providing eligible

own funds equal to the SCR necessary to support the undertakings insurance obligations over their lifetime.

04/12/23 9

Solvency Capital Requirement [SCR]

“The economic capital to be held by an undertaking in order to ensure that ruin occurs no more than once in 200 cases”

The SCR corresponds to the Value at risk of the basic own funds of an undertaking subject to a confidence level of 99.5% over a one year holding

The SCR can be calculated based on the standard formula as set out in the directive an internal model, subject to Financial Regulator approval.

04/12/23 10

Solvency Capital Requirement [SCR]

The Solvency Capital Requirement are in relation to All existing business Expected new business for the next 12 months

The Solvency Capital Requirement covers Non Life underwriting risk Life underwriting risk Health underwriting risk Market risk Credit risk Operational risk

04/12/23 11

Minimum Capital Requirement 1

[MCR]

The Minimum Capital Requirement is A capital value which triggers regulatory intervention The amount below which the amount of financial

resources should not fall It must be calculated quarterly A report showing the results must be submitted to

the Financial Regulator The results cannot be less than 25% of the SCR or

greater than 45% of the SCR.

04/12/23 12

Minimum Capital Requirement 2 [MCR]

If the value slips below the minimum capital requirement: The authorisation of a firm is withdrawn unless the

minimun capital can be achieved in a short period of time.

04/12/23 13

Pillar Two

System of Governance

Own risk and Solvency Assessment

Oversight and Control Functions

Outsourcing

Supervisory Review Process

04/12/23 14

System of Governance 1Article 41

An effective system of governance to ensure sound and prudent management of the business proportionate to the nature, scale and complexity of the undertaking

The system of governance must be subject to review

04/12/23 15

System of Governance 2

The system of governance must include An adequate and transparent organisational structure Clear allocation and segregation of duties An effective system for transmission of information Documented Policies and Procedures which must be

reviewed at least annually or more often if there are any material changes

04/12/23 16

Documented Policies and Procedures

Documented Policies and Procedures which must be reviewed at least annually or more often if there are any material changes

Policies must at least cover Risk management Internal control Internal auditing Outsourcing

Documented Policies and Procedures are subject to prior approval by the Financial regulator (Article 41.3)

04/12/23 17

Own risk and Solvency Assessment

(ORSA)

All undertakings must Assess overall solvency needs with a view to their risk

profile Complete a regular review Identify any deviations form the assumptions underlying

the regulatory capital calculation Be specific to the undertakings risk profile – dependent

on the complexity of the undertaking Provide the result to the Financial Regulator If an internal model is used for the calculation of the SCR,

the result can be used for the ORSA.

04/12/23 18

Oversight and Control Functions

Internal Control System (Article 46)

Undertakings are required to have internal controls which include:

An internal control framework Compliance function Administration procedures Accounting procedures Reporting process

The compliance function is responsible for all aspects of compliance including laws, regulations, directives and any other industry rules.

04/12/23 19

Oversight and Control Functions

Internal Audit Function (Article 47)

All undertakings must have an internal audit function which is responsible for evaluating : the adequacy of the internal control system the effectiveness of the internal control system Evaluating any other elements of the governance

system

04/12/23 20

Oversight and Control Functions

Actuarial Function (Article 48)

All undertakings must have an actuarial function which is responsible for: Assessing the adequacy of the methodology and model

used to calcualte the technical provision Co-ordinating and overseeing the calcualtion of the

technical provision Assess the adequacy of the data used and any

assumptions in the calculation of the technical provision Expressing opinions on the underwriting policies and

reinsurance arrangements Support the effective implementation of the risk

management system - particularly in relation to the ORSA

04/12/23 21

Outsourcing

Solvency 2 permits outsourcing but full responsibility remains with the undertaking.

The FR must be informed prior to outsourcing of any critical or important function Of any material developments in relation to these

outsourced functions

The undertaking must review and monitor the outsourcer Document the review to a standard acceptable to the

FR

04/12/23 22

Supervisory Review Process 1(SRP)

The Financial Regulator will regularly review and evaluate the The quantitative and qualitative compliance of the

undertaking in relation to its operating environment Current and potential risks

04/12/23 23

Supervisory Review Process 2

The review will consider System of governance and risk assessment Technical provisions Capital requirements Investment rules Quality and quantity of own funds Use of full or partial internal model

Following the review the FR can require an undertaking to remedy any discovered weakness or deficiency. Under Article 37 a Capital Add On can be imposed if the undertaking has deviated from it underlying assumptions.

04/12/23 24

Financial RegulatorConsultation Paper 41 (CP41)

Published by Financial Regulartor on 27th April 2010

Sets the minimum requirements for credit institutions and insurance undertakings (life and non life )

Membership of boards Role of the chairman Operation of board committees

04/12/23 25

Pillar 3Disclosures

An annual report on solvency and financial condition

The report must include: A description of the business and the undertakings

performance A discription of the governance system and an

assessment of its adequacy for the risk profile of the undertaking

A risk assessment for each category of risk – risk exposure, concentration, mitigation and sensitiviy

A description for each asset, technical provision , other liabilities with bases and methods of valuation

A description of the capital management

04/12/23 © John Brady 201026

Disclosures

Capital Management disclosures must include The structure and amount of own funds, and their quantity The amount of the MCR The amount of the SCR and the option used to calculate it Information which allows for an understanding of the main

differences between the underlying assumptions of the standard formula and those of any internal model used in calculating the SCR

The amount of any non compliance with the MCR with explanations and consequences as well as remedial action taken.

The amount of any significant non compliance with the SCR with explanations and consequences as well as remedial action taken.

04/12/23 27

Implementation of Solvency 2

The Financial regulator has set out four steps to implementation Implement an appropriate governance framework Appoint an execute with responsibility for overseeing the

implementation (the Financial regulator recommends there should be a specific Board member responsible)

Performa gap analysis to identify shortfalls Implementation should focus on all three Pillars

The Financial Regulators needs to be informed of the Person appointed and if the undertaking intends to use an internal model

04/12/23 28