News and Views

Solvency II is based upon three pillars

At a glance

Pillar 1 contains two capital requirements, the Minimum Capital Requirement (MCR) and the Solvency Capital Requirement (SCR). The MCR reflects an absolute minimum level of required capital below which supervisory action will automatically be triggered. The SCR represents additional capital to firms to absorb significant unforeseen losses.

Pillar 2 will focus on supervisory activities of regulators with the aim of identifying firms with a higher risk profile. Those firms may be required to hold capital at a higher level than the amount suggested by the SCR calculation and/or to take steps to reduce identified risks.

Pillar 3 requires disclosure of additional information that supervisors feel they need in order to perform their regulatory functions.

In more detail 

Pillar 1
The exact relationship between the Minimum Capital Requirement (MCR) and Solvency Capital Requirement (SCR) has yet to be determined, but the SCR will be the key driver. Unlike the MCR it will be fully risk-based, taking into account all the risks inherent in a business, mainly underwriting, credit, operational, liquidity and market risk. A firm that cannot demonstrate capital levels adequate to meet these risks will have to submit a concrete plan to their regulator for approval with a realistic timeframe included.

Calculating the SCR
Insurers and reinsurers will be required to measure their risks and ensure that they have sufficient capital to cover them. There is still some debate over the probability of solvency in any one year that a company should be required to demonstrate. 99.5% looks the most likely outcome, though a number of alternative options have been suggested ranging from 95% to 99.9%.

Firms are likely to have two options. They will be able to adopt a standardised approach or an internal model.

The standardised approach is closer to the system of regulation currently in force in most EU states. It is less time-consuming, but is based on averages and there is a considerable amount of guesswork involved. To compensate for this uncertainty and for the greater margin of error, Solvency II is likely to build in additional capital requirements for those using the standardised approach.

For companies choosing the modelling route, regulatory approval will be required before a firm is able to use its internal model to calculate SCR. Models are more time-consuming, though we point out elsewhere on the site (modelling for insurers and reinsurers) that it has a number of compelling business advantages quite apart from regulatory drivers.

Solvency II will also permit a hybrid approach involving simplified models with an element of standardisation. This may be attractive to smaller and medium-sized insurers unable to justify investment in full-scale models.

Pillar 2
Pillar 2 has two main aims:
• to ensure that a firm is well run and meets adequate risk management standards;
• to ensure that it is adequately capitalised.

The first of these represents a major development since Solvency I and will encourage firms to adopt Enterprise Risk Management. It will be much more than a question of going down a list and ticking boxes. The regulator will want to be satisfied about the quality of data and estimation procedures, the systems in place to manage risk and action plans in the event of certain risks materialising. An understanding of how different risks inter-relate may also be necessary.

Pillar 3
Pillar 3 is about disclosure and demonstrating to the regulator that the analysis supporting the other two pillars is dependable. It requires insurers to provide key, verifiable information relevant to their capital adequacy. In broad terms, these would cover:
• measures of financial condition and performance;
• measures of risk profiles and the data and other assumptions upon which they are based;
• measures of uncertainty, including the accuracy or otherwise of previous estimates and the sensitivity of the calculations to market volatility.