Download PDF Understanding Solvency II, What is different after October 2013

Solvency II

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Under the new regime, they must validate modeled losses using historical loss data. That is simply too little loss information to validate a European windstorm model, especially given the recent lull, which has left the industry with scant recent claims data. That exacerbates the challenge for companies building their own view based only upon their own claims.

The model includes the most up-to-date long-term historical wind record, going back 50 years, and incorporates improved spatial correlation of hazard across countries together with a enhanced vulnerability regionalization, which is crucial for risk carriers with regional or pan-European portfolios. For Solvency II validation, it also includes an additional view based on storm activity in the past 25 years.

Windstorm clustering—the tendency for cyclones to arrive one after another, like taxis—is another complication when dealing with Solvency II. It adds to the uncertainties surrounding capital allocations for catastrophic events, especially due to the current lack of detailed understanding of the phenomena and the limited amount of available data.

To chip away at the uncertainty, we have been leading industry discussion on European windstorm clustering risk, collecting new observational datasets, and developing new modeling methods. We plan to present a new view on clustering, backed by scientific publications, in These new insights will inform a forthcoming RMS clustered view, but will be still offered at this stage as an additional view in the model, rather than becoming our reference view of risk.

We will continue to research clustering uncertainty, which may lead us to revise our position, should a solid validation of a particular view of risk be achieved. The scientific community is still learning what drives an active European storm season. Some patterns and correlations are now better understood , but even with powerful analytics and the most complete datasets possible, we still cannot yet forecast season activity.

However, our recent model update allows re insurers to maintain an up-to-date view, and to gain a deeper comprehension of the variability and uncertainty of managing this challenging peril. That knowledge is key not only to meeting the requirements of Solvency II, but also to increasing risk portfolios without attracting the need for additional capital. It can improve a wide range of risk management decisions, from basic geographical risk diversification to more advanced deterministic and probabilistic modeling. The need to capture and use high quality exposure data is not new to insurance veterans.

The underlying logic of this principle is echoed in the EU directive Solvency II, which requires firms to have a quantitative understanding of the uncertainties in their catastrophe models; including a thorough understanding of the uncertainties propagated by the data that feeds the models. The implementation of Solvency II will lead to a better understanding of risk, increasing the resilience and competitiveness of insurance companies.

Firms see this, and more insurers are no longer passively reacting to the changes brought about by Solvency II. Increasingly, firms see the changes as an opportunity to proactively implement measures that improve exposure data quality and exposure data management. And there is good reason for doing so: As a result, many reinsurers apply significant surcharges to cedants that are perceived to have low-quality exposure data and exposure management standards.

Conversely, reinsurers are more likely to provide premium credits of 5 to 10 percent or offer additional capacity to cedants that submit high-quality exposure data. Rating agencies and investors also expect more stringent exposure management processes and higher exposure data standards. Sound exposure data practices are, therefore, increasingly a priority for senior management, and changes are driven with the mindset of benefiting from the competitive advantage that high-quality exposure data offers.

However, managing the quality of exposure data over time can be a challenge: To fight the decrease of data quality, insurers spend considerable time and resources to re-format and re-enter exposure data as its being passed on along the insurance chain and between departments within each individual touch point on the chain. However, due to the different systems, data standards and contract definitions in place a lot of this work remains manual and repetitive, inviting human error. This month we have the 25th anniversary of the most damaging cluster of European windstorms on record—Daria, Herta, Wiebke, and Vivan.

This cluster of storms highlighted the need for better understanding the potential impact of clustering for insurance industry.

However, since then we have not seen such a clustering again of such significance, so how important is this phenomena really over the long term? There has been plenty of discourse over what makes a cluster of storms significant, the definition of clustering and how clustering should be modeled in recent years. Today the industry accepts the need to consider the impact of clustering on the risk, and assess its importance when making decisions on underwriting and capital management.

However, identifying and modeling a simple process to describe cyclone clustering is still proving to be a challenge for the modeling community due to the complexity and variety of mechanisms that govern fronts and cyclones. But the insurance industry is mostly concerned with severity of the storms. Thus, how do we define a severe cluster? Are we talking about severe storms, such as those in and , which had very extended and strong wind footprints.

There are actually multiple descriptions of storm clustering, in terms of storm severity or spatial hazard variability. Without a clearly identified precedence of these features, defining a unique modeled view for clustering has been complicated and brings uncertainty in the modelled results. This issue also exists in other aspects of wind catastrophe modeling, but in the case of clustering, the limited amount of calibration data available makes the problem particularly challenging. Moreover, the frequency of storms is impacted by climate variability and as a result there are different valid assumptions that could be applied for modeling, depending on the activity time frame replicated in the model.

For example, the s and s were more active than the most recent decade. A model that is calibrated against an active period will produce higher losses than one calibrated against a period of lower activity. Due to the underlying uncertainty in the model impact, the industry should be cautious of only assessing either a clustered or non-clustered view of risk until future research has demonstrated that one view of clustering is superior to others. RMS offers clustering as an optional view that reflects well-defined and transparent assumptions.

By having different views of risk model available to them, users can better deepen their understanding of how clustering will impact a particular book of business, and explore the impact of the uncertainty around this topic, helping them make more informed decisions. This transparent approach to modeling is very important in the context of Solvency II and helping re insurers better understand their tail risk. Right now there are still many unknowns surrounding clustering but ongoing investigation, both in academia and industry, will help modelers to better understand the clustering mechanisms and dynamics, and the impacts on model components to further reduce the prevalent uncertainty that surrounds windstorm hazard in Europe.

In working towards model validation, companies may find their experience of European windstorm hazard does not match the modeled loss. The underlying timelines for each dataset may simply differ, which can have a significant influence for a variable peril like European windstorm. Looking over the short term, the last 15 years represented a relative lull in windstorm activity , particularly when compared to the more extreme events that occurred in the very active s and s.

The enhanced RMS model includes the RMS reference view, which is based on the most up-to-date, long-term historical record, as well as a new shorter historical dataset that is based on the activity of the last 25 years. On 13 November , following months of uncertainty, agreement was finally reached between the European trialogue parties on the Omnibus II Directive and a final compromise text was published shortly afterward. The deal includes a package of measures to facilitate insurance products with long-term guarantees and transitional measures both for EU insurers and third countries moving towards equivalence.

Insurers will continue to be able to match long-term liabilities with investments in long-term assets such as infrastructure projects. Omnibus II also contains measures to mitigate the effects of artificial volatility, such as a matching adjustment for annuity business, a volatility adjustment, extrapolation of the risk-free interest rate, transitional measures and the extension of the recovery period. Clarity on the final provisions of Omnibus II and the implementation timetable was welcomed across the industry.

The latest transposition and application dates are now unlikely to change meaning firms can resume preparation for the new regime on the basis that provisions to implement Solvency II rules into national law will be passed by 31 March , and the regime will apply in full from 1 January The Prudential Regulation Authority PRA proposes applying the guidelines in a proportionate, risk-based manner according to the nature, scale and complexity of the business. As Omnibus II negotiations rumbled on, the PRA adopted its own planning period to implementation particularly in relation to firms involved in the internal model approval process.

It is worth noting that whilst agreement on Omnibus II remained elusive, work continued on global supervisory initiatives with the International Association of Insurance Supervisors IAIS leading the way. The ICPs act as a benchmark for insurance supervisors and encourage adaptation of national regulatory frameworks to comply with global standards. The ICS will be introduced by the end of , followed by two years of testing by supervisors and internationally active insurance groups.

During and the European Commission undertook a review of EU insurance law in order to improve consumer protection, modernise supervision, deepen market integration and increase the international competitiveness of European insurers and reinsurers. The current solvency system is over 30 years old and financial markets have developed significantly since then, leading to a large discrepancy between the reality of insurance business today and its regulation.

The reforms have been driven forward as a consequence of the European Commission concluding that there are widespread divergences in the implementation of the existing insurance directives across the EU and wishing to ensure that the insurance sector has a comparable regulatory and prudential regime to that of the banking and securities sectors in the EU. Solvency rules stipulate the minimum amounts of financial resources that insurers and reinsurers must have in order to cover the risks to which they are exposed.

The rules also lay down the principles that should guide insurers' overall risk management so that they can anticipate any adverse events and handle such situations more effectively. The new solvency requirements have been designed to ensure that insurers have sufficient capital to withstand adverse events, both in terms of insurance risk as under the previous regime , and now also in terms of economic, market and operational risk. Solvency II is to be adopted in accordance with the 'Lamfalussy' process. The Lamfalussy process takes a four-stage approach to the introduction of financial services regulation.

In the first stage a framework directive is proposed after a full consultation process. At stage two technical implementing measures or 'delegated acts' under Omnibus II are introduced; much of the detail is added at this stage. The third stage involves work on recommended guidance and non-binding standards which are not included in the legislation. Finally, the fourth stage of the process requires the European Commission to monitor compliance by Member States. Solvency II will be based on a 'three pillar' framework. The pillar system originates from the approach taken in the Capital Requirements Directive, which followed the international Basel II Accord for banks and investment firms.

Under the first pillar insurers are required to maintain reserves against liabilities technical provisions. A consistent market-based system is applied for assessing liabilities as well as ensuring a greater matching of assets to liabilities. Insurers and reinsurers must adhere to a Minimum Capital Requirement MCR , which is the fundamental level of solvency required of any insurer. If the MCR is breached, supervisory action will be taken. The Solvency Capital Requirement SCR represents the target level of solvency which an insurer or reinsurer needs to maintain.

It is a fully risk-based calculation which can be made either through a standard formula or by using internal models or a combination of both. Basically the SCR is the amount of capital needed to leave a less than 1 in chance of capital being inadequate over the forthcoming year. The Directive requires that insurers and reinsurers invest their assets in accordance with the 'prudent person' principle and they should invest in such a manner as to 'ensure the security, quality, liquidity and profitability of the portfolio as a whole'.

Insurers will be required to submit their own assessment of risk and solvency capital adequacy known as the ORSA.

In addition, they must submit details of their internal systems and controls. Should it be seen to be necessary, supervisors may require a 'capital add-on'. It might be that the supervisor will request that further capital be injected into the SCR following the review process, although this should only occur when the supervisory authority concludes that the risk-profile of the insurer 'deviates significantly' from the assumptions underlying the SCR. The third pillar harmonises disclosure requirements.

Where are we now?

Insurers are required to report publicly on their financial condition, providing information on capital. In summer , EIOPA published a series of reports in response to consultations launched towards the end of Insurers are expected to have the necessary competence and expertise to find 'fit-for-purpose solutions' for the practical challenges of the ORSA.

EIOPA points out that proportionality is a key feature of the ORSA and insurers should develop tailored processes to fit their own organisational structure and risk management systems. Finally, the report notes that undertakings are required to submit a forward-looking assessment of their overall solvency needs to national supervisory authorities, indicating multi-year tendencies and developments. EIOPA will revisit each of these reports once the final Level 2 implementing measures have been agreed in order to verify whether any amendments to the criteria change the conclusions reached.

Understanding Solvency II

At the same time, EIOPA will consider whether any changes made to the Bermudan, Japanese and Swiss solvency and prudential regimes affect the assessments. Once the review is complete the European Commission will decide upon the equivalence of these third countries. The European Commission has developed a transitional regime for Solvency II equivalence for third countries which either have a risk-based regime similar to Solvency II, or are willing and committed to move towards such a regime over a pre-defined period 5 years in the initial proposal.

For those third countries that have indicated that they are interested in being covered by the transitional provisions, the European Commission requested that EIOPA carry out a 'gap analysis'. EIOPA sent these countries requests for information in order to carry out the analysis. EIOPA's work is of a technical nature only. It will be up to the European Commission to decide which third countries will be included in the equivalence transitional regime.

The process is subject to adoption of Omnibus II. There is no definitive date but the Commission is expected to decide on equivalence sometime in A number of UK consultations were published in which considered the rules required to transpose the Solvency II Directive. The FSA launched the second consultation on transposition in July Part 2 includes proposed rules and guidance on areas that were not covered, or were only partially covered, in the first consultation and focused in particular on: The consultation closed in October HM Treasury consulted separately on legislative amendments to ensure that UK regulators have the powers necessary to implement the Directive.

The consultation closed on 15 February It is unclear when the outcome of this consultation will be published. This consultation proposed changes to the FSA rules and guidance relating to the operation of unit-linked and index-linked insurance policies primarily contained in COBS 21 to ensure consistency with the requirements of Solvency II. The feedback statement, published in June , confirmed the FSA's intention to make the proposed amendments to COBS 21 and addressed some general points raised by respondents. The FSA began receiving submissions from those firms that are currently in the pre-application phase of the internal model approval process IMAP on 30 March Initially, the FSA had allocated submission slots to firms between 30 March and mid The FSA also confirmed that internal model applications should be based on the Level 2 text and proposed cross-referencing the text with its guidance materials.

Areas of weakness identified included: The PRA stated that this was the most pragmatic way forward and allows firms more time to complete the work they need to do for their submissions. EIOPA received over comments during the consultation period and issued final guidelines on 27 September The guidelines were addressed to National competent authorities NCAs which had to decide how best to implement the guidelines into their national regulatory or supervisory framework by the application date of 1 January The statement came into effect on 1 January and will cease to operate on the day prior to implementation of Solvency II, 1 January The statement explains that the PRA expects firms to have regard to the outcomes in the guidelines whilst also continuing to meet the existing PRA rules.

Whilst the guidelines are generally consistent with existing PRA handbook provisions, firms are required to implement the substantive provisions in order to ensure that they are ready for the new regime. The PRA sought to be proportionate in its application of the guidelines to ensure that there is a minimal risk of two regimes running concurrently. For each of the four areas of preparation the statement identifies where firms need to focus their efforts and where the guidelines require more than existing PRA handbook provisions. The key issues are summarised below.

Disagreement on the treatment of long-term guarantees in times of market stress had stalled EU negotiations on the final Omnibus II text. EIOPA published the results of the LTG assessment which considered the following six regulatory measures aimed at ensuring an appropriate supervisory treatment of long-term guarantee products under volatile market conditions:.

Solvency II | The RMS Blog

Based on the outcome of the assessment, EIOPA supported subject to some minor amendments the inclusion of the extrapolation, classical matching adjustment, extension of the recovery period, and transitional measures. EIOPA also advised the trialogue parties to replace the CCP with a formulaic, more reliable measure, known as the 'volatility balancer'.

EIOPA recommended excluding the extended matching adjustment altogether, whilst retaining the 'classical' matching adjustment. Adams encouraged firms to reassess priorities and make a concerted push to ensure compliance. Firms will need to continue to meet existing regulatory requirements until Solvency II is implemented. Where possible, the PRA will look for ways that firms may be able to use their preparations for Solvency II to meet the current supervisory regime.

Introduction

The Solvency II Directive (Directive //EC [recast]) was adopted in In October , EIOPA issued Guidelines on the Preparatory Phase to promote. After almost a decade in the making, Solvency II will apply from 1 January proposed in October delaying Solvency II for a second time. Under Solvency II‚ insurers will be required to take account of all types of.

It will play a key role in supporting the threshold condition that insurers must have appropriate non-financial resources and robust risk and capital management systems. The PRA thinks it reasonable to expect firms to be ready for Solvency II based reporting six months before implementation, meaning that firms falling within the thresholds should be able to submit their reports in July The PRA will continue to review the practicability of the reporting timetable but warns firms to prepare for higher quality reports and better synchronised reporting under Solvency II.

The first stage of the review looks at the approach and methodology used by firms, and the second stage will focus on the actual calculation of technical provisions. The PRA intends to publish information in the first quarter of on the progress of the first stage as well as an update on the second stage, which has been deferred as a result of Omnibus II delays. Now that the timetable is certain, firms must be prepared for their IMAP submission slots.

Solvency II part 3)

Capital add-ons - Article 37 of the Solvency II Directive prescribes the limited circumstances in which a capital add-on can be applied. Supervisors can apply a capital add-on where the risk profile is not in line with that in the SCR or there are significant governance deficiencies. The right is only supposed to be used in 'exceptional circumstances'. Once imposed a capital add-on is to be reviewed at least annually by the regulatory authority. If the deficiencies that led to its imposition have been remedied then the capital add-on is to be removed. The method and process for calculating and imposing capital add-ons are expected to be set out in the Level 2 legislation and further explained in the Level 3 guidance.