What is “Solvency II”?
Solvency II is an insurance regulation directive set out by the European Union. The purpose of this directive is to coordinate the insurance industry across the union.
The directive is divided up into three pillars. The first pillar is capital adequacy and sets out quantitative requirements known as solvency capital requirements (SCR). This pillar requires companies to maintain enough capital to meet requirements. Its main objective is to ensure insurance companies hold enough capital to sustain their solvency. This available capital is detailed in Solvency II as ‘own funds’.
The second pillar deals with risk management and governance. The provisions under this pillar require companies to ensure the regulatory framework is aligned with their own risk management and business decisions. It also puts in place rules for effective supervision.
The third pillar has to do with disclosures, ensuring transparency for all the stakeholders, and improving comparability among competitors.
Key Learning Points
- Solvency II is a European Union directive that regulates the insurance industry in the region
- The three pillars under Solvency II are capital adequacy, risk management and governance, and disclosure
- The first pillar relates to capital adequacy and requires the insurance company to maintain a solvency capital requirement (SCR) which is a higher level of capital, below which a regulator may be involved to replenish capital levels
- The second pillar relates to governance and ensures the organization has enough internal rules in place to properly manage risk
- The third pillar regulates disclosures and ensures transparency
First Pillar – Capital Adequacy
The first pillar is the most useful when it comes to financial analysis. Under this pillar, Solvency II has two levels of capital requirements.
The initial level is known as the solvency capital requirement (SCR). This is a higher level of capital requirement a company must maintain. If the level of available capital drops below this amount, a regulator can intervene and ask the company to take action to provide remedies in order to bring the level back up. A remedy could include requiring the company to halt its dividend payments.
The second is the minimum capital requirement (MCR). This sets out the minimum level of capital an insurance company must have in order to operate. This is a lower amount than SCR. If available capital drops below this level, the company will be required to cease its operations.
Since SCR is a higher level of capital requirement, available capital falling below this level is one of the first red flags for analysts and can be a good indicator of how a company manages its capital.
Second Pillar – Risk Management and Governance
For a Solvency II compliant company, these governance rules must be followed in order to ensure the company has an efficient risk management system.
Some of the requirements include definitions of key functions, internal controls, written policies in place, and prudent management of the business.
The pillar also requires supervision to be in order, part of which included regular internal review provided to the regulator, where the company bears the burden of proof.
These rules have been purposely left vague so that the organization can interpret and adapt them to fit its own business model. The company is required to then publish its own Risk and Solvency Assessment (ORSA) which is to be disclosed to the regulator.
Third Pillar – Disclosures
This pillar aims to make the financial movements within the whole market more transparent. This pillar introduces companies to produce both annual and quarterly financial reporting and for it to be relevant, reliable, and comprehensible.
Having consistent reporting across all of the industry also helps comparability, allowing for improved competition.