From Solvency I to
Solvency II
Prof. Karel Van HulleKU Leuven and Goethe University Frankfurt
Member IRSG – EIOPA
Serbian Insurance Days
Arandjevolac, 29 November 2017
Insurance regulation under Solvency I
• Was boring: very difficult to explain to an outsider how to
calculate the solvency margin under Solvency I
• Insurance regulation was highly prescriptive and
paternalistic
• Insurance regulation was very legalistic and did not reflect
the economics of the insurance business model
• Insurance regulation was more concerned with
policyholder protection than with insurance
• Insurance supervisors were considered less important or
qualified than their banking colleagues
Prof. Karel Van Hulle - KU Leuven
and Goethe University Frankfurt
2
Insurance supervision under Solvency I
• Insurance supervision was often limited to a detailed
scrutiny of a number of forms
• Form over substance – tick the box exercise
• Insurance supervisors rarely engaged directly with
supervised entities
• Insurance supervisors rarely had direct market experience:
employment moves between supervision and industry or
vice versa were often seen as suspect
• Insurance supervisors preferred detailed rules rather than
a principles based approach, requiring judgment
Prof. Karel Van Hulle - KU Leuven
and Goethe University Frankfurt
3
The birth of Solvency II
• For the EU, Solvency II is the most important change in
insurance regulation since the last 30 years
• The birth of Solvency II was very much helped by the
capital market crisis at the beginning of this century
• Crucial elements of Solvency II are:
o The introduction of an economic risk based approach
o The linkage between risk and capital
o The crucial role to be played by risk management
• The need to move in the direction of a risk based solvency
capital regime is now recognised throughout the world
Prof. Karel Van Hulle - KU Leuven
and Goethe University Frankfurt
4
Prof. Karel Van Hulle - KU Leuven
and Goethe University Frankfurt
5
Why Solvency II?
• Solvency I as designed in the 70’s was not sufficiently risk
based
• Solvency I did not encourage insurers to better manage
their risks
• Solvency I did not attach sufficient importance to the
qualitative aspects of supervision
• Solvency I did not include an early warning signal
• Solvency I did not attach sufficient importance to group
supervision
• Solvency I did not take account of progress in banking,
accounting, actuarial science
Other reasons
• After 30 years, it was time to modernize the regulatory
framework for insurance
• Action was needed before the Solvency I regime would
break down because of a changed environment
• A more efficient allocation of capital would allow the
insurance industry to take on more risks
• Supervisory convergence could only come about when
moving away from minimum harmonization
• Recent changes in banking regulation could produce
regulatory arbitrage inciting insurers to engage in more
risky behaviour
Prof. Karel Van Hulle - KU Leuven
and Goethe University Frankfurt
6
Principle objectives of Solvency II
• Deepen the Single Market
• Enhance policyholder protection and financial stability
• Improve (international) competitiveness of EU insurers
• Further better regulation
Prof. Karel Van Hulle - KU Leuven
and Goethe University Frankfurt
7
Ways and means to achieve this
• Establishment of risk sensitive capital requirements to
encourage and reward good risk management
• Emphasis on the responsibility of senior management to
manage their business responsibly
• Fostering of greater supervisory convergence
• Institution of a regular dialogue between supervisor and
supervised entities
Prof. Karel Van Hulle - KU Leuven
and Goethe University Frankfurt
8
Prof. Karel Van Hulle - KU Leuven
and Goethe University Frankfurt
9
Solvency II: 3 pillars and a roof
Pillar 1: quantitative requirements
1. Harmonised calculation of technical provisions
2. "Prudent person" approach to investments instead of
current quantitative restrictions
3. Two capital requirements: the Solvency Capital
Requirement (SCR) and the Minimum Capital Requirement
(MCR)
Pillar 2: qualitative requirements and
supervision
1. Enhanced governance, internal control, risk
management and own risk and solvency assessment (ORSA)
2. Strengthened supervisory review, harmonised supervisory
standards and practices
Pillar 3: prudential reporting and public
disclosure
1. Common supervisory reporting
2. Public disclosure of the financial condition and solvency
report
(market discipline through transparency)
Group supervision & cross-sectoral convergence
Groups are recognised as an economic entity=> supervision on a consolidated basis(diversification benefits, group risks)
Pillar I: Quantitative Requirements
• Market consistent valuation (fair value) of assets and liabilities
• Total balance sheet approach
• Two capital requirements: SCR with confidence level of 99.5% VaR over a one year time horizon and MCR with absolute floor
• Calculation of SCR based upon standard formula or an internal model (full or partial) approved by the supervisor
• No lists of eligible assets or limits on investments (Prudent Person Rule)
• Credit for risk mitigation (securitisation, derivatives, reinsurance) and for diversification
Prof. Karel Van Hulle - KU Leuven
and Goethe University Frankfurt
10
Capital and technical provisions
• What is capital in an insurance undertaking? How to deal
with long term liabilities?
• Market consistent valuation of technical provisions: best
estimate and risk margin (based on cost of capital)
• Efficient allocation of capital
o Two capital requirements with supervisory ladder of
intervention
o SCR is target level of capital: no need to provide for
excessive capital (breach of SCR = invite for cup of tea)
o Capital is only one of the measures to ensure solvency
Prof. Karel Van Hulle - KU Leuven
and Goethe University Frankfurt
11
• Qualitative requirements to cover risks which are not
covered in the SCR
• Enhanced internal control, governance and risk
management, as well as self-assessment of capital needs
(ORSA) with a forward looking approach
• Strengthened supervisory review, harmonised supervisory
standards and practices
Pillar II: Qualitative Requirements
Prof. Karel Van Hulle - KU Leuven
and Goethe University Frankfurt
12
General governance requirements
• From implicit to explicit governance
• Effective system providing for sound and prudent
management
• Adequate and transparent organisational structure
• Clear allocation and appropriate segregation of
responsibilities
• Effective system for ensuring transmission of information
• Proportionality principle
• Persons in charge of key functions, members of the Board
and persons effectively running the business must be fit
and proper
Prof. Karel Van Hulle - KU Leuven
and Goethe University Frankfurt
13
Governance functions
• General principles
o Written policy
o Prior approval by the Board
o Regular review (annually or in case of significant
changes)
• Key functions
o Risk management including ORSA
o Internal control and compliance
o Internal audit
o Actuarial
Prof. Karel Van Hulle - KU Leuven
and Goethe University Frankfurt
14
Objectives of the ORSA
• ORSA should ensure that an insurer does not engage in
business for which it does not have sufficient capital
• ORSA should allow an insurer to assess the quality and
quantity of financial resources available to it, relative to its
needs
o NO SEPARATE CONSIDERATION OF RISK AND
CAPITAL
o ORSA IS THE DNA OF AN INSURANCE
UNDERTAKING
15Prof. Karel Van Hulle - KU Leuven
and Goethe University Frankfurt
What should ORSA be?
• A continuous process to ensure that risk and solvency are
key factors in the insurer’s decision making
• A key component of an insurer’s risk management culture
• A project that is supported by all key stakeholders, based
on a clear plan and a clear allocation of responsibilities
16Prof. Karel Van Hulle - KU Leuven
and Goethe University Frankfurt
What should ORSA not be?
• ORSA should not become a compliance reporting exercise
(no box ticking)
• ORSA should not be performed solely for the benefit of the
supervisor
• ORSA should not be seen or be used as a new capital
requirement
• ORSA should not replace regulatory capital requirements
17Prof. Karel Van Hulle - KU Leuven
and Goethe University Frankfurt
Pillar III: Disclosure & Reporting
• Public disclosure and Supervisory Reporting
• New approach in Pillar 1 and Pillar 2 means new
approach needed for Pillar 3!
• More freedom for firms to run themselves; but with new
responsibilities new requirements for disclosure to
harness market discipline in support of achieving the
regulatory objectives = public disclosure
• Power and discretion for supervisors: need to earn trust
of stakeholders; need to foster supervisory convergence
& achieve competitive equality new requirements for
transparency = supervisory reporting
Prof. Karel Van Hulle - KU Leuven
and Goethe University Frankfurt
18
Public disclosure
• The Solvency and Financial Conditions Report (SFCR) is
disclosed on an annual basis from May 2017 onwards
• The SFCR follows a prescribed structure:
o Description of business and performance
o Description and assessment of the adequacy of the
system of governance
o Risk profile
o Valuation for solvency purposes
o Capital management
o Summary
Prof. Karel Van Hulle - KU Leuven
and Goethe University Frankfurt
19
Supervisory reporting
• Solvency and Financial Condition Report (annually)
• Regular supervisory report (at least every 3 years)
o Business and performance
o System of governance
o Risk profile
o Valuation for solvency purposes
o Capital management
• ORSA supervisory report (at least annually)
• Annual quantitative templates developed by EIOPA
• Quarterly quantitative templates developed by EIOPA
• Exemptions may apply for SMEs under certain conditions
Prof. Karel Van Hulle - KU Leuven
and Goethe University Frankfurt
20
Reinforcement of group supervision
• Identification and nomination of a group supervisor
• Rights and duties of the group supervisor for all key
elements of group supervision
• Enhancement of the duty to exchange information
• Full recognition of diversification benefits
• Internal model to calculate the group SCR
• Group ORSA and Group Solvency and Financial Condition
Report
• Subroups: maximum three levels of supervision
Prof. Karel Van Hulle - KU Leuven
and Goethe University Frankfurt
21
Proportionality
• Account must be taken of the nature, scale and complexity of the operations of each (re) insurance undertaking. This means:
o Regime should not be too burdensome for small andmedium-sized undertakings
o Proportionality applies not only to the requirements imposed by law (three pillars) but also to the exercise of supervisorypowers
o Example: combination of governance functions
o Proportionality also means that if the operations of an insurance undertaking are complex, more stringent rules might have to be applied
o Proportionality is never about “if” but about “how”. The resultcan never be zero.
22Prof. Karel Van Hulle - KU Leuven
and Goethe University Frankfurt
Prof. Karel Van Hulle - KU Leuven
and Goethe University Frankfurt
23
Impact of financial crisis
• QIS 5 (2011) showed high volatility in the solvency capital
and in own funds as a result of market instability
• Volatility was caused by measurement of liabilities at
market value
• Difficulty to define a risk free discount rate to apply to the
valuation of long term liabilities
• Difference in life products between MS requires different
solutions to remove “artificial” volatility
• Transition from Solvency I to Solvency II was made difficult
because of the change in the discount rate
• Low interest rate environment
Omnibus II
• Directive 2014/51/EU of 16 April 2014:
o Amends the Solvency II Framework Directive (2009)
and the EIOPA Regulation (2011):
• Powers and responsibilities of EIOPA
• Organizes the implementation of the Framework Directive and
sets the date of first time application at 1 January 2016
• Proportionality (for instance, reporting obligations)
• Temporary and provisional equivalence (third country regimes)
• Long term guarantee package
• Phasing-in and transitional provisions
• Review clause (2020)
Prof. Karel Van Hulle - KU Leuven
and Goethe University Frankfurt
24
Omnibus II turns SII into a project in 4 stages
• Framework Directive containing the principles of the new
solvency regime adopted by Council and EP (level 1)
• Implementation of the Framework Directive by the EC
through a Delegated Act (Regulation): scrutiny of Council
and EP (from 3 to 6 months) (level 2)
• Regulatory and Implementing Technical Standards
developed by EIOPA which become legally binding after
endorsement by the EC (level 3)
• Guidelines / Recommendations developed by EIOPA
addressed to supervisors and/or insurers and which are
applicable on a “comply or explain” basis (level 4)
Prof. Karel Van Hulle - KU Leuven
and Goethe University Frankfurt
25
Commission Delegated Regulation
• Adopted on 10 October 2014 (300 p.)
• Based upon 76 empowerments in the Solvency II
Framework Directive as amended by Omnibus II
• Prepared on the basis of a formal Call for Advice sent to
EIOPA in March 2009
• Advice provided to the EC (Nov. 2009 - Jan. 2010)
• Draft prepared by EC and consulted upon in the course of
2010-2011 and amended after adoption of Omnibus II
• Legal form of Commission Regulation (single rulebook)
• Sets first review date for standard formula in 2018
Prof. Karel Van Hulle - KU Leuven
and Goethe University Frankfurt
26
Early lessons from Solvency II
• Insurers and insurance supervisors have difficulties to
work with a principle based approach
• Insurance supervisors look at the SCR as the MCR!
• Insurers are developing strategies to optimize capital
• EIOPA stress tests show that most insurers are well
capitalised
• Risk management of most insurers has improved
• Insurance and insurance regulation/supervision is taken
more seriously (also by banking supervisors)
• Supervisory colleges are playing an important role in
furthering a single European rulebook
Prof. Karel Van Hulle - KU Leuven
and Goethe University Frankfurt
27
Prof. Karel Van Hulle - KU Leuven
and Goethe University Frankfurt
28
Role of EIOPA
• EIOPA as technical adviser to the EC and to the EP with
leadership role for technical issues concerning insurance
supervision (RTS and ITS)
• EIOPA now represented in all (92) colleges of supervisors
• EIOPA responsible for developing common supervisory
culture
• Binding mediation, peer reviews
• Cooperation with ESRB
• Clear mandate to further develop market conduct rules
• Assisted by two stakeholder groups (IRSG and OPSG)
EIOPA tools for supervisory convergence
• Guidelines and recommendations
• Monitoring of implementation in practice
• Supervisory colleges
• Supervisory handbook
• Peer reviews
• Bilateral engagements with national competent authorities
• Balance sheet reviews
• Country reviews
• Technical assistance
• Binding mediation
Prof. Karel Van Hulle - KU Leuven
and Goethe University Frankfurt
29
Concluding remarks
• Solvency II puts more emphasis on the responsibility of
each individual undertaking
o Investment strategy (prudent person)
o Asset-Liability management
o Governance functions
o Own risk and solvency assessment
• Solvency II recognises the strength and the weakness of
human nature: more focus on risk management and
governance
• Solvency II cannot work without a change in management
and supervisory culture
Prof. Karel Van Hulle - KU Leuven
and Goethe University Frankfurt
30
Prof. Karel Van Hulle - KU Leuven
and Goethe University Frankfurt
31
Prof. Karel VAN HULLE
Research Center Insurance
Faculty of Economics and Business
KU Leuven
Naamsestraat 69 Box 3525, B-3000 Leuven
International Center for Insurance Regulation
Faculty of Economics and Business Admin.
Goethe University – House of Finance
Th.-W.-Adorno-Platz 3, D-60629 Frankfurt/ Main