Solvency ii Study Notes

What is Solvency II
 European regulatory framework for insurance and
reinsurance and is based on the economic principles
regarding the measurements of assets and liabilities
 improved customer protection, increased
supervision, market integration and competitiveness
 three pillar model
 European Union (EU) focus but with a worldwide
ripple effect
 International benchmark effective from January 2014

Aims of Solvency II
 Improved Customer Protection
 To provide policyholders across the EU with
 A greater degree of protection and
 an increased level of consistency
 reduce the losses suffered by policyholders in the
event the insurance firm is unable to meet its claims
fully.

Aims of Solvency II (cont.)
 Modernised Supervision
 “Supervisory Risk Review”
 To implement procedures to
 Identify,
 measure, and
 manage risks levels
 by introducing a comprehensive risk measurement framework to
determine the required level of capital.
 The Need
 to readdress weaknesses in the system
 create consciousness towards a more modernised industry
standard
 improve industry risk management practices.

 Deepened EU Market Integration
 Potentially change the competitive outlook of the
insurance industry
 through capital allocations which will impact
 pricing and
 product innovations.
 This combined with customer protection may provide
policyholders with greater confidence in insurer products.

 Increased International Competitiveness of EU
Insurers
EU subsidiaries of non-EU parent
company or group of companies
 must adhere to supervision requirements aims to
protect all policyholders of European insurers
 readily transferable capital from risk associated
with coverage from the wider group of which they
are apart of.
 EU parent companies with non-EU subsidiaries will
have to
 face changes under the new Solvency II

The three pillars
 Similar to the banking industry’s Basel II Three
Pillar framework
 include quantitative and qualitative requirements as
well as market discipline
 focus on risk, capital, supervision and disclosure
according to KPMG (2011)
 Different applications and requirements for
Solvency II

Pillar I: Capital Requirements
 Quantitative quality
 Divided into
1) Solvency Capital Requirements (SCR)
2) Minimum Capital Requirement (MCR)
 is to ensure firms have risk-based capital
 calculated using an internal model, a standard
formula or a combination of the two
 Three tests to be passed
 Statistical Quality
 Calibration and
 Use test

(SCR) (cont.)
Internal Model approach Standard Formula approach
sets out various tests to determine
compliance
attempts to provide for arrange of
risks faced by the insurer and is
intended for use by small to medium
sized enterprises
complex and costly and the
regulations had to provide for all
members of the industry
risks are categorized whereby
separate Solvency Capital
Requirements are determined
value-at-risk is determined by the
changes to a pre-specified shock
[Private Equity and Venture Capital
Association (2011)]
value-at-risk is determined by the
changes to a pre-specified shock
Combination approach (Internal Model and Standard Formula)
Same requirements as those of the Internal Model
Narrower scope for the combination approach – than that of Internal Model

(SCR)
The Statistical Quality Test
 evaluates the base quantitative methodology of the internal model
 insurer must be able to show the relevance of this methodology
including the
 choice of model inputs and parameters,
 rationalize the assumptions underlying the model.
The Calibration Test
 must show the regulatory capital requirement determined by the
internal model, fulfils the requirements set out in the modelling
criteria by the supervisor.
 Internal model results
 assessed and
 insurer’s regulatory capital requirements compared to the to those
of other insurers.
The Use Test
 requires the model, methodologies and results are incorporated in
the risk strategy and operational processes of the insurer

(MCR)
According to KPMG (2011):
 designed to be the lower solvency
calculation, corresponding to a solvency
level, below which policyholders and beneficiaries
would be exposed to an unacceptable level of
risk, if the insurer were allowed to continue its
operations.
 The Minimum Capital Requirements are
calculated a linear function of specified variables
and
 MCR limits, cannot be
 25% below insurer’s SCR limit
 Above 45% insurer’s SCR limit

Pillar II: Governance and
Supervision
 Qualitative quality
 to ensure a higher risk management system by
enforcing
 a higher degree of standards of risk management and
 governance within a firm’s organisation.
 Greater powers (for supervisors) to challenge risk
management issues of the firm with “Supervisory
review and intervention”.
 Includes Own Risk and Solvency Assessment
(ORSA), requires
 the insurer to determine self-assessment risks for
future endeavours,
 the necessary consequent capital requirements, and

Pillar II: Governance and
Supervision (cont.)
The qualitative requirements are determined
according to: (KPMG (2011))
1. An overall responsibility of risk management
2. A clearly defined risk strategy which is linked to
the business strategy
3. An ongoing management and control over the
company’s risk-bearing capacity.
 Organizational setup and all the processes
relating to management of the business
environment must be
 documented and formalized
 in order to be communicated to a supervisory
authority.

Pillar III: Disclosure
 Requirements regarding disclosure of both
1. public to the market place
 public report is a solvency and financial condition report:
 enhances the level of disclosure needed by the insurer
2. private to the supervisor
 The private report is an annual report:
 made to supervisors
 concerning various matters relating to the firm
 Requires insurers to publish details regarding the risks
facing the insurer regarding their capital adequacy and
risk management.
 Ensures an insurer’s general financial position is better
represented with more recent and relevant information
 Thus transparency of the insurance industry in the market
environment and
 Greater discipline on the industry as whole.

Pillar III: Disclosure
 Pillar III is similar to that of Pillar I as it refers to
quantitative information as opposed to Pillar II’s
qualitative information.
Requires
 insurers to produce a Solvency and Financial
Condition report on a yearly basis.
 firms to characterize and update the company
disclosure report, technical requirements, and
complete Solvency II documentation on the
procedures to be followed and implement the
reporting cycle run.
 Other Solvency II impacts?

The Impact of Solvency II on the
Private Equity Investing Facet
Europe
 Insurers with excess capital together with a compelling
financial position and diversified portfolios pertaining to
high risk bearing capacity are unlikely to be affected by
Solvency II (European Private Equity and Venture
Capital Association (2011))
 Solvency II may provide opportunities for investment into
the asset class
 national insurance regulation that
 deters investments in private equity across Europe, as a
result,
 Can be used to combat the restrictions placed by those
insurance regulations because of it’s
 “prudent person principle” approach

(cont.)
Asset managers and investors
 Certain investments will be preferred in comparison to
others which are seen as too capital consuming due to the
capital requirements on investment risks.
 The introduction of capital charges on investment risks
may cause insurers to take less investment risks than
before.
 insurers condensing their shares in property and equities
 opt to increase their share of higher rated fixed-income
securities
 to reduce capital requirements within their investment
portfolio.
 No exclusion on the various classes of assets
 Must prove that the assets comply with the Prudent
Person Investment Principle (PPIP)
 PPIP states that investors are able to invest in any asset of
its choosing provided the risks involved are
understood, proper provision is made for the risk or

The Impact of Solvency II on the
(cont.)
Asset Managers
 direct and indirect effect which will result in insurers
reviewing their asset allocation.
 Ernst & Young (2012) suggest that asset managers
should assist insurance clients in managing their
balance sheets
 by creating their own adaptation of the Solvency
Capital Requirement (SCR).
 SCR is a risk based approach
 affects the investment decision making process as it
 takes into consideration the return after the risk and the
capital cost of the risk.

Non-EU parent companies with
European subsidiaries
 firms operating within Europe will be required to display
their group’s ability to
 accurately measure their risks
 manage the risks.
 Irrespective of where the parent company is situated
 For Solvency II equivalents, the global insurance firm will
need to prove its ability to cover its risks with sufficient
capital
 so as to not pose a risk to European policyholders.
 KPMG (2011) states that global insurers doing this will
 Provide the lead regulator in Europe with a look into the
entity
 Need to show the lead regulator that they intend to
harmonize with the group’s supervisory requirements ito the
Solvency II directive.

What becomes of non-EU
subsidiaries with EU parent
companies
 Subsidiary companies from the United States (U.S)
of an EU parent company
 obliged to consolidate with their EU parent company
and
 adhere to the Solvency II groups’ requirements
applicable to their European parent company.
 For other significantly held non-EU subsidiaries of
an EU parent company
 will have to comply with vital aspects of the Solvency II
regime locally.
 Complying will impact the risk management, capital
administration, data and system implications of the
subsidiary.

Solvency II implications for South
Africa
 Although Solvency II is aimed at restructuring the
insurance industry in Europe, it will cause a ripple effect
worldwide.
 EU requires the ability to understand (KPMG 2011)
 key risks facing an organization and the
 controls and processes put in place to manage those risks
 Capital requirements to cover those risks by proving them
 Main components of EU factors:
1. Establishing the main intergroup transactions that
exist between the overseas organisation and the
European entity.
2. Determining key group risks that could potentially
impact the European entity.
3. Identifying the shared services provided to the
European entity and the plans to ensure Solvency II

Solvency II implications for South
Africa (cont.)
 The Financial Services Board (FSB) currently in the process
of implementing a risk-based supervisory regime for the
prudential regulations of the insurance industry in South
Africa.
 Solvency Assessment and Management (SAM) is the
Solvency II equivalent
 Noteworthy changes (using SAM) to both long-term and
short-term insurers ito:
 establishing their technical provisions,
 capital adequacy and
 their ability to manage risks in the business and
 transparency through reporting to the public and the Regulator.
 SAM Steering Committee has formulated a Tax Task Group
 to deliberate the tax implications that are to occur under SAM
and

Implication of Solvency II for the
hedge fund industry
 the investment strategy of the insurer,
 Interaction between insurer, and investment managers and
other service providers are of importance when fulfilling the
Solvency II requirements.
 review as to what Solvency II means for the hedge fund
industry.
a) could result in insurers taking potentially penalizing capital
charges against their hedge fund holdings however it also
provides uncertainty in the market place and may result in
b) insurers may postponing hedge fund allocations due to
market place uncertainty
 Penalises portfolios that do not provide clarity as to their
underlying assets.
 Without details regarding the portfolio’s holdings and risk
exposure hedge funds are classified as “other equities” in the
standard formula and are thus subjected to a 49% capital

hedge fund industry (cont.)
 However Solvency II News (2012)
(www.solvencyiinews.com) states that hedge fund
can steer clear of the 49% capital charge with
 Insurance firm (investing in the hedge fund) build an
internal model to showcase that funds risks do not call
for a 49% capital charge.
 Ito Pillar II (governance and supervision) in Solvency
II,
 hedge fund managers and insurers will need to create
a new service level agreement that will be able to factor
in the needs of Solvency II
 Thus allow for a compliant relationship ito the act.
 Insurers need to confirm that their investment
managers or hedge fund managers are operating
effectively and efficiently and are under continuous

hedge fund industry (cont.)
Deloitte (2010) state
 Quarterly deadlines ito reporting under the Pillar III
framework
 Will create a deadline issue in acquiring the
necessary data within that time frame and
 Made worse for firms that outsource their back-office
activities.
 specific types of data supplied by the investment
manager need to be re-evaluated in order to
 determine the capital charges required ito Pillar I and
 ensure that there is a level of disclosure regarding a
greater degree of the information pertaining to the
investments.
 Hedge fund managers can use data management

Conclusion
 The implementation of the Solvency II regime will
bring
 clarity and assurance
 to policyholders whilst being a complex procedure for
current industry members.
 Status: The regime is currently running behind
schedule,
 Thus insurance industry and others affected by the
new regulations, have an opportunity to better
prepare themselves for the institution and impact of
Solvency II not only locally but globally.

Solvency ii Study Notes

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