25.07.2016
All risks considered

Pillar I: Capital requirements under Solvency II

At the start of 2016, European insurers have entered a new era: Solvency II has introduced a set of uniform rules for the industry, making risks visible at an early stage and requiring insurers to take appropriate precautions.

Solvency II requires insurers to have sufficient financial means – more precisely: own funds – to survive negative events that, statistically speaking, occur only once in 200 years. These so-called “1-in-200” risks include e.g. major losses caused by natural catastrophes or extreme disruptions in equity and bond markets.

Risks are covered by own funds
The required level of capital/own funds depends on the obligations and risks associated with a company’s business model and/or investment strategy.
An insurer’s own funds correspond to the market value of its assets minus its liabilities. For instance, any drop in the current market value of equities triggers a drop in the level of assets in the solvency balance sheet, and accordingly leads to declining own funds. On the liability side of the solvency balance sheet, an insurer may face declining own funds if its technical provisions are insufficient to cover the benefits promised to policyholders – e.g. if a property insurer has to cover the effects of several high-impact natural catastrophes in a short period of time.

How much capital do insurers need?
To ensure that they are always able to pay out benefits, insurers need a capital buffer to balance their decreasing own funds in the unlikely case of rare risk events. The key supervisory standards for the required capital buffer are the Solvency Capital Requirement (SCR) and the Minimum Capital Requirement (MCR). SCR and MCR are based on complex model calculations taking all the insurer’s relevant risk scenarios into account.

If the level of own funds is not sufficient to cover the solvency capital requirement, the supervisory authority may require the insurer to take appropriate measures (e.g. raising own funds through capital increase or reduction of risk profile through sale of riskier assets). Insurers failing to meet the MCR are subject to strict supervisory measures and may even lose their business license.

The ratio of an insurer‘s own funds to the solvency capital requirement (SCR) is also referred to as solvency ratio. If the own funds exceed the solvency capital requirement, the solvency ratio amounts to over 100 percent. If the own funds are not sufficient to meet the solvency capital requirement, the solvency ratio is below 100 percent.
Companies with a solvency ratio above 100% have sufficient capital reserves for negative scenarios that – statistically speaking – only occur once in 200 years. Companies with a solvency ratio of e.g. 90% do not fully meet this requirement. However, they are still able to meet their current and future obligations – in all likelihood, this also holds true for most negative scenarios.

Change to the new system made possible by transitional measures
Solvency II harmonises regulatory provisions for 28 EU member states with heterogeneous markets and – up to now – specific national supervisory systems. Implementing the new rules is a highly complex task for insurers – and the historically low interest rates at the start of the new system do not make it any easier. In order to ensure a smooth transition of the 28 existing systems to the new set of rules, all European insurers may apply so-called transitional measures (transitionals).

The transitional measure on technical provisions is particularly important for German life insurers, which traditionally offer long-term guarantees. Due to this transitional, insurers may implement the Solvency II provisions on the valuation of guarantees gradually, over a period of 16 years, taking the valuation according to the German Commercial Code as a starting point. This measure does not apply to new insurance policies.


 
GOOD TO KNOW
Life insurers have to build up sufficient provisions for their long-term guarantees. They have to calculate how much capital they need to invest today in order to be able to pay out the promised benefits tomorrow. For instance, if the benefits are payable in the distant future and the assumed interest rates underlying the contract are low, the insurer has to build up comparatively low provisions – and the other way around.

Under Solvency I, the assumed interest rate was based on the average interest rate level of the past years. Under Solvency II, by contrast, insurers have to value their liabilities at current market rates. To be able to calculate the required provisions for existing liabilities with very long durations, insurers do not only need to know the current level of interest rates – they must also make estimations regarding future rates. For this reason, the new system includes a so-called interest rate term structure, allowing insurers to determine future interest rates based on the current interest situation.

Due to the massive drop in interest rates since 2008, existing liabilities under Solvency II have to be valued higher than before. For this reason, insurers have to make higher provisions than before the drop in interests, including for contracts that had been entered into decades ago and under a fundamentally different supervisory system. Insurers can build up the required own funds gradually over a period of 16 years.


 

More:
>> Solvency II – Here is how it works