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«Solvency II Overview – Frequently asked questions Brussels, 12 January 2015 1. What is Solvency II? The Solvency II regime introduces for the first ...»

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European Commission - Fact Sheet

Solvency II Overview – Frequently asked questions

Brussels, 12 January 2015

1. What is Solvency II?

The Solvency II regime introduces for the first time a harmonised, sound and robust prudential

framework for insurance firms in the EU. It is based on the risk profile of each individual insurance

company in order to promote comparability, transparency and competitiveness.

Solvency II (Directive 2009/138/EC) - as amended by Directive 2014/51/EU ('Omnibus II') - replaces 14 existing directives commonly known as 'Solvency I'.

2. Why was Solvency II necessary?

Over its 40 years of existence, the 'Solvency I' regime showed structural weaknesses. It was not risk- sensitive, and a number of key risks, including market, credit and operational risks were either not captured at all in capital requirements or were not properly taken into account in the one-model-fits-all

approach. This lack of risk sensitivity had the following consequences:

- Owing to its simplistic model, Solvency I does not lead to an accurate assessment of each insurer's risks;

- It does not ensure accurate and timely intervention by supervisors;

- It does not entail an optimal allocation of capital, i.e. an allocation which is efficient in terms of risk and return for shareholders.

The Solvency II framework, like the Basel framework for banks, proposes to remedy these

shortcomings. It is divided into three 'pillars':

- Pillar 1 sets out quantitative requirements, including the rules to value assets and liabilities (in particular, technical provisions), to calculate capital requirements and to identify eligible own funds to cover those requirements;

- Pillar 2 sets out requirements for risk management, governance, as well as the details of the supervisory process with competent authorities; this will ensure that the regulatory framework is combined with each undertaking's own risk-management system and informs business decisions;

- Pillar 3 addresses transparency, reporting to supervisory authorities and disclosure to the public, thereby enhancing market discipline and increasing comparability, leading to more competition.

Capital requirements under Solvency II will be forward-looking and economic, i.e. they will be tailored to the specific risks borne by each insurer, allowing an optimal allocation of capital across the EU. They will be defined along a two-step ladder, including the solvency capital requirements (SCR) and the minimum capital requirements (MCR)[1], in order to trigger proportionate and timely supervisory intervention.

The new regime will also eliminate existing restrictions imposed by Member States on the composition of insurers' investment portfolios. Instead, insurers will be free to invest according to the 'prudent person principle'[2] and capital requirements will depend on the actual risk of investments.

As for insurance groups, the same approach will be applied as for individual insurers so that groups will be recognised and managed as economic entities. In capital requirements, diversification benefits will be recognised, meaning that the total risks of a group are less than the sum of the risks of its entities. This will also contribute to a more efficient capital allocation for shareholders.

The new regime will also promote greater cooperation between national insurance supervisors that oversee the subsidiaries of any given group, with a stronger role for the group supervisor. The European Insurance and Occupational Pensions Authority (EIOPA) is tasked with ensuring that the single rule book is applied consistently throughout Europe. EIOPA also has mediating powers in case disagreements emerge between national supervisory authorities when supervising cross-border groups.

3. What does the Delegated Act (implementing rules) add to the Solvency II Directive?

The implementing rules contained in the delegated act which is due to enter into force on the day following publication in the Official Journal, aim to set out more detailed requirements for individual insurance undertakings as well as for groups, based on the provisions set out in the Solvency II Directive (see IP/14/1119). They will make up the core of the single prudential rulebook for insurance and reinsurance undertakings in the Union. They are based on a total of 76 empowerments[3] in the

Solvency II Directive and in particular cover the following areas:

- rules for the market-consistent valuation of assets and liabilities, including technical provisions; in particular, the rules set out technical details of the so-called 'long-term guarantee measures' which were introduced by the Omnibus II Directive to smooth out artificial volatility and ensure that insurers can continue to provide long-term protection at an affordable price;

- rules for the eligibility of insurers' own fund items, covering capital requirements to improve the risk sensitivity of the regime and allow timely supervisory intervention;

- the methodology and calibration of the Minimum Capital Requirement (MCR) and of the standard formula for the calculation of the Solvency Capital Requirement (SCR); this includes the calibration of market risks on insurers' investments, taking into account the Commission’s long-term financing agenda (see question 5);





- for undertakings applying to use an internal model to calculate their SCR, the implementing rules also specify standards that must be met as a condition for authorisation;

- the organisation of insurance and reinsurance undertakings' systems of governance, in particular the role of the key functions defined in the Directive (actuarial, risk management, compliance and internal audit); the implementing rules also specify some aspects of the supervisory review process and the elements to consider in deciding on an extension of the recovery period for undertakings that have breached their SCR;

- reporting and disclosure requirements, both to supervisors and to the public; the increased comparability and harmonisation of information is intended to improve the efficiency of supervision and foster market discipline;

- criteria for supervisory approval of the scope of the authorisation of special purpose vehicles taking on reinsurance risk, and requirements related to their operation;

- rules related to insurance groups, such as the methods for calculating the group solvency capital requirement, the operation of branches, coordination within supervisory colleges, etc.; and

- criteria to assess whether a solvency regime in a third country is equivalent.

4. When will the new rules become applicable? Are there transitional provisions?

The Solvency II Directive, along with the Omnibus II Directive (see MEMO/13/992) that amended it, will have to be transposed by Member States into national law before 31 March 2015. On 1 April 2015, a number of early approval processes will start, such as the approval process for insurers' internal models to calculate their Solvency Capital Requirement. The Solvency II regime will become fully applicable on 1 January 2016. This timeline – in parallel with EIOPA's set of guidelines on preparing for Solvency II – allows supervisors and undertakings to prepare for the application of the new regime.

In addition, Solvency II includes a number of measures to ensure a smooth transition from Solvency I,

mostly:

- two measures on the valuation of technical provisions, helping the transition to a marketconsistent regime over 16 years;

- tolerance for insurers breaching the Solvency Capital Requirement within the first two years;

- grandfathering of existing hybrid own-fund items that are eligible under Solvency I, making it easier to meet the new capital requirements and giving the industry 10 years to adapt the composition of its capital to Solvency II standards;

- longer deadlines to report quarterly and annual information to supervisors and to disclose reports to the public, decreasing gradually from 20 weeks to 14 weeks after the close of the reporting period over the first 3 financial years.

5. How do the implementing rules contribute to a proportionate application of Solvency II, particularly for small and less complex insurers?

The principle of proportionality is an integral part of the Solvency II regime, meaning that a proportionate application of Solvency II should also apply to small and less complex undertakings.

Solvency II will apply to almost all insurers and reinsurance undertakings licensed in the EU. Only the smallest undertakings (typically, undertakings that are not part of a group and write less than EUR 5 million in premiums per year) will be exempt from the new rules, although they may choose to apply them if they wish. Small insurance undertakings play an important role in the economic environment and should not be subjected to unnecessary regulation.

Examples of proportionality lie mostly in the implementing measures (delegated act) and include:

- simplified methods for the calculation of technical provisions;

- simplified methods for the calculation of the capital requirement;

- asset-by-asset data is not required for collective investments; data may be grouped under certain conditions;

- exemptions are introduced from the use of International Financial Reporting Standards (IFRS) in the valuation of assets and liabilities for undertakings that do not already use IFRS for their financial statements;

- with respect to governance, key functions may be shared, including the internal audit function, in certain circumstances;

- with respect to reporting by smaller insurers:

- quarterly reporting is of core data only;

- supervisors can waive quarterly reporting partly or entirely, and some of the annual reporting for smaller undertakings;

- supervisors can decide to require narrative reporting only every three years (though it would normally be annually).

6. What does Solvency II do to stimulate long-term investment by insurers?

European insurers are the largest institutional investors in Europe’s financial markets. It is crucial that prudential regulation should not unduly restrain insurers’ appetite for long-term investments, while properly capturing the risks.

First, the capital requirements are designed to strongly incentivise insurers to match the duration of assets and liabilities. A perfect match in duration could reduce massively capital requirements[4].

Besides, on certain portfolios where cash-flows are matched and insurers can hold fixed-income assets to maturity, they may use the 'matching adjustment' which smoothes out artificial volatility on their balance sheet and significantly reduces the capital requirement corresponding to the risk of short-term spread fluctuations (see question 8). Therefore, the design of the capital requirements will increase insurers' appetite for long-term assets.

Second, Solvency II will repeal the investment limits imposed by Member States regarding certain investments, in particular less liquid ones such as infrastructure. Instead, insurers will be free to invest according to the 'prudent person principle' and capital requirements will depend on the actual risk of their investments. The standard formula for the calculation of market risk must be sufficiently detailed to cater for different asset classes, featuring different risk profiles.

More tailored treatment of these assets has the added advantage of increasing the risk-sensitivity of the capital requirements and thereby promoting good risk management and supporting the prudential robustness of the overall regime. The identification of a high-quality category of securitisation based on the criteria set out in the European Insurance and Occupational Pensions Authority (EIOPA)'s advice on high-quality securitisation from December 2013) is significant in this respect. It will encourage insurers to invest in simpler securitisations, which are more transparent and standardised, thereby reducing complexity and risk and promoting sound securitisation markets which are needed in the EU (see section below on securitisation).

Other specificities of the standard formula to stimulate long-term investment by insurers include:

s favourable treatment of certain types of investment fund that have been created recently under EU legislation, such as European Social Entrepreneurship Funds and European Venture Capital Funds. (Note: the European Long-Term Investment Fund Regulation was still under negotiation at the time of adoption of the Solvency II delegated act. It was therefore legally impossible to cater explicitly for ELTIF funds at the time of adoption of the implementing measures);

s similarly favourable treatment of investments in closed-ended, unleveraged alternative investment funds, which captures in particular other private equity funds and infrastructure funds other than the European Funds mentioned above;

s investment in infrastructure project bonds are treated as corporate bonds, even when credit risk is tranched, instead of being treated as securitisations. This is aligned with their treatment under banking regulation (See recital (50) of Regulation (EU) No 575/2013 (the Capital Requirements Regulation (EU) No 575/2013) on prudential requirements for credit institutions and investment firms.);

s several measures focused on unrated bonds and loans (targeting in particular SMEs and

infrastructure projects):

- insurers investing in unrated bonds and loans can use proxy ratings (e.g. using the rating of the issuer or of other debt instruments which are part of the same or similar issuing programmes). The same provisions exist in banking regulation (see article 139 of the Capital Requirements Regulation (EU) No 575/2013) and help to reduce overreliance on ratings by avoiding punitive capital treatment for unrated instruments;

- where unrated debt instruments are guaranteed by collateral, the risk-mitigating effect of the collateral on spread risk is recognised;



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