Solvency II review to strengthen insurance sector - EN | BNPP AM UK professional investor (2023)

Now awaiting passage into law is a major review of the 2016 Solvency II regulation governing the solvency capital requirements (SCR) of European insurers. The amendments proposed by the European Commission (EC) and the European Insurance and Occupational Pensions Authority (EIOPA) are intended to ensure the insurance sector remains fully resilient to future market shocks.

BNP Paribas Asset Management’s Sophie Debehogne, Senior Client Solution Manager, Solution and Client Advisory Group (Multi Asset Quantitative and Solutions Group), and Mehdi Hacini, Quantitative Analyst, Quantitative Research Group, argue that while the EC proposal does not revolutionise Solvency II, eight of the amendments it contains do have important implications for insurance companies. In a new paper, they explain why.

Read the full paper “Solvency II: Adjusting the dial but no revolution” here

The aim of the Solvency II review is not to undermine the insurance industry’s solvency, which is reasonably strong and has resisted the Covid-19 crisis well.

Rather, the proposed amendments are intended to better align Solvency II with:

  • Market realities, for example a low return environment and its associated risks
  • Insurers’ long-term investment horizon profile and their significant role as contributors to the economy
  • The particular nature and credit sensitivity of individual insurance companies
  • Reducing the industry’s sensitivity to market fluctuations
  • Being better able to deal with certain risks, such as those linked to climate change.

Overall, the EC expects the proposed measures to free up EUR 90 billion of capital in the short term. That said, as measures such as those concerning the discount curve and interest-rate shocks look set to increase insurers’ capital requirements, the actual amount of freed capital will likely be reduced to EUR 30 billion over the long term.

The eight amendments likely to have the most impact

1. Modification of the discount curve

There will be a new Risk Free Rate (RFR) curve to discount insurers’ liabilities. The proposed extrapolation method takes into account information on longer-term market interest rates beyond 20 years for a more natural distribution of interest-rate sensitivities over the curve for liabilities.

It will better align ‘regulatory’ sensitivities over the curve with the true ‘market’ curve than does the current method.

There will be a transition period to the end of 2031 from the existing curve to the new one. While the envisioned transition mechanism will initially have no impact on the curve’s level, it will affect the interest-rate sensitivity of liabilities from day one.

Broadly, the consequence of this change in the RFR curve is that insurers hedging some of their liabilities to contain their SCR will have to adjust their hedging strategy.

2. Amendment relating to interest-rate shocks

The second big change concerns interest-rate shocks. Under the existing Solvency II regulation, such shocks are based on a matrix that provides a relative percentage variation to apply to the interest rate for each maturity between Year 1 and Year 90. The matrix is different depending on whether interest rates move suddenly higher or lower. The percentages also decrease with the maturities.

As this approach creates an asymmetry between the curves relating to upward and downward shocks, the EIOPA and the EC are seeking to better align this SCR module with current market conditions.

The impact of these changes will mainly concern:

  • Life insurers with long-duration liabilities and a marked duration mismatch between their assets and liabilities. In particular, lifer insurers with some cash and short-term exposures will have a high capital charge.
  • More generally, insurers with a duration mismatch.

3. New approach to calculating the volatility adjustment

The volatility adjustment (VA) aims to mitigate the short-term volatility of insurers’ solvency, taking into account their long-term perspective. It reduces the impact of short-term changes in credit spreads on the valuation of insurance liabilities, thus helping to make capital resources less volatile.

Under the proposals, the way of calculating the VA will change, such that the size of the VA is more dependent on the situation and credit sensitivity of each insurer rather than using a default VA for all insurers (Exhibit 1).

Solvency II review to strengthen insurance sector - EN | BNPP AM UK professional investor (1)

4. Changes to eligibility for long-term equity investments (LTEI)

The EC has reviewed the eligibility criteria for the long-term equity investment (LTEI) module, which was designed to better take into account the long-term nature of insurers’ activity and help the sector to finance the economy.

The complexity of the criteria has inhibited the use of this module. To make LTEI more attractive to insurers, the proposed eligibility conditions will be simplified and help ensure that the equity pocket covers either long-term liabilities or that there will be no forced sale simply to meet liabilities.

5. Adjustment of the correlation matrix

The EIOPA proposes only changing the correlation matrix in cases of downward interest-rate shocks. The change concerns exclusively the correlation between the spread and the interest-rate risks, which has been reduced from 50% to 25%. This will broadly reduce the total market solvency capital requirement for insurers with a large interest-rate and spread SCR.

6. Broadening of the symmetric equity adjustment bandwidth

The symmetric equity adjustment is used to reduce the procyclical character of an insurer’s equity investment. The objective is to make equities less expensive in terms of SCR after a market drop and more expensive after a market rise.

This symmetric adjustment was initially defined at a minimum of -10% and a maximum of +10%, based on the current level of a reference portfolio compared to its average over the last three years. In reviewing Solvency II, this bandwidth will likely be broadened to -17% to +17%.

The main objective is to reduce procyclicality and avoid the insurance industry having to sell equity positions at the worst time, such as after a market drop.

7. Risk margin reduction

The risk margin regulated by Solvency II is designed to cover non-hedgeable risks should an insurer’s activity be transferred to a third party. The proposed revision aims to reduce the size and volatility of the risk margin as the current formula is viewed as being too conservative.

8. Introduction of climate change scenario analysis

The EC will introduce a requirement for insurers to conduct analyses of the impact of climate change on their activities and financial results. The objective is to ensure that the insurance industry better takes into account and manages climate risks and the associated systemic risks.


Solvency II review to strengthen insurance sector - EN | BNPP AM UK professional investor (2)

Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience.Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.


Does Solvency II apply to UK? ›

The Government Actuary's Department (GAD) played a key supporting role in HM Treasury's review of Solvency II. This governs the prudential regulation of insurance firms in the UK.

What is Solvency 2 review UK? ›

Solvency II is the regime that governs the prudential regulation of insurance firms in the UK. This call for evidence is the first stage of the review of Solvency II. The review is underpinned by three objectives: to spur a vibrant, innovative, and internationally competitive insurance sector.

What are Solvency II requirements for insurers? ›

Under Solvency II, capital requirements are determined on the basis of a 99.5% value-at-risk measure over one year, meaning that enough capital must be held to cover the market-consistent losses that may occur over the next year with a confidence level of 99.5%, resulting from changes in market values of assets held by ...

What is Solvency II review summary? ›

Description. Solvency II established a framework for supervision of Europe's insurance sector, underpinning the importance of a risk-based approach to assessing and mitigating risks. With the overarching objective of strengthening policyholder protection, the framework continues to work well.

Does Solvency II apply to USA? ›

The implications vary depending on how directly impacted a given U.S. company is by Solvency II. In the United States, the companies most interested in the development of Solvency II are U.S.-domiciled subsidiaries with parent companies located in the European Union (EU).

What are Solvency II capital requirements UK? ›

Under Solvency II, capital requirements are determined on the basis of a 99.5% value-at-risk measure over one year, meaning that enough capital must be held to cover the market-consistent losses that may occur over the next year with a confidence level of 99.5%, resulting from changes in market values of assets held by ...

What is proof of solvency UK? ›

A solvency certificate is a document that is required by law in order to prove that a company is able to pay its debts. The certificate is issued by a company's accountant and must be renewed every year.

What is the minimum solvency ratio for insurance companies UK? ›

Explore more financial-related content here

A regulation requiring a SCR ratio of 100% means that insurers are required to hold eligible assets in reserve to the value of 100% of what they could be liable to lose over the next year.

What is a UK Solvency II firm? ›

A UK Solvency II firm means a firm: (1) that satisfies the conditions set out in 2.2, or. (2) whose Part 4A permission includes a requirement that it comply with the Solvency II Firms Sector of the PRA Rulebook. 2.2.

What are the 4 key functions Solvency II? ›

of the Solvency II Directive concerning the “system of governance” for all insurance undertakings. The four functions are the risk-management function, the compliance function, the internal audit function, and the actuarial function.

What is Solvency II explained simply? ›

Solvency II is the prudential regime for insurance and reinsurance undertakings in the EU. It has entered into force in January 2016. Solvency II sets out requirements applicable to insurance and reinsurance companies in the EU with the aim to ensure the adequate protection of policyholders and beneficiaries.

What are the basics of Solvency II? ›

Solvency II is a risk-based capital regime, similar in concept to Basel II, based on three "pillars". Pillar 1 is a market consistent calculation of insurance liabilities and risk-based calculation of capital. Pillar 2 is a supervisory review process. Pillar 3 imposes reporting and transparency requirements.

What are the three pillars of Solvency II? ›

The regulation consists of three pillars: quantitative requirements, supervisory review and market disclosure.

What is a good solvency score? ›

Acceptable solvency ratios vary from industry to industry, but as a general rule of thumb, a solvency ratio of less than 20% or 30% is considered financially healthy. The lower a company's solvency ratio, the greater the probability that the company will default on its debt obligations.

What are Solvency II data requirements? ›

The Solvency II directive cites three key criteria for data quality which insurers must measure: accuracy, completeness and appropriateness. Legal responsibility for data quality ultimately lies with the insurer, regardless of how the data is sourced or aggregated.

What is the purpose of solvency 2? ›

Solvency II sets out regulatory requirements for insurance firms and groups, covering financial resources, governance and accountability, risk assessment and management, supervision, reporting and public disclosure.

Which countries have Solvency II equivalence? ›

Switzerland – to be granted full equivalence for reinsurance, group supervision and group solvency. Australia, Bermuda, Brazil, Canada, Mexico and the USA – to be granted provisional equivalence (for 10 years) for group solvency (for Bermuda, this excludes captives).

What is the minimum capital ratio for Solvency II? ›

Since the introduction of Solvency II, insurance companies are required to hold eligible own funds at least equal to their SCR at all times in order to avoid supervisory intervention, i.e. the SCR coverage ratio, defined as eligible own funds divided by SCR, is required to be at least 100%.

What is the minimum capital requirement in the UK? ›

There is a minimum allotted share capital requirement, known as the “authorised minimum”, which is currently set at £50,000 and which must be denominated in sterling. The same minimum share capital requirement applies where a private company re-registers as a public company under Part 7 of the Act. 1065.

What are the changes to solvency 2 UK? ›

The Government states that it will legislate as necessary to implement the new Solvency regime. The changes to Solvency II relate to: risk margin (RM); matching adjustment (MA); increasing investment flexibility; and reducing reporting and administrative burdens.

What is the minimum capital requirements for UK banks? ›

Capital requirements under CRD IV and the CRR

a CET1 capital ratio of 4.5% a Tier 1 capital ratio of 6% and. a total capital ratio of 8%.

What is solvency UK? ›

the ability to pay all the money that is owed: Questions were raised about the financial solvency of the university.

What is required for solvency test? ›

A company is regarded as solvent if it is able to meet its debts as and when due within 12 months immediately after distribution is made.

What does solvency tell you about a company? ›

Key Takeaways

Solvency is the ability of a company to meet its long-term debts and other financial obligations. Solvency is one measure of a company's financial health, since it demonstrates a company's ability to manage operations into the foreseeable future.

What is the best estimate liability in solvency 2? ›

Best estiMate liaBility The Best Estimate Liability is the unbiased estimate of the present value of expected future cash flows. In other words, the cash flows are valued using best estimate assumptions with no explicit margins incorporated.

What is the best solvency ratio in insurance? ›

All insurance companies in India are required to maintain a solvency ratio of 150 per cent or 1.5 to minimise the risk of bankruptcy as per the current regulations by the Insurance Regulatory and Development Authority of India (Irdai).

Which insurance company has the highest solvency ratio? ›

1. Life Insurance Corporation of India (LIC India)
  • LIC claim settlement ratio: 97.79%
  • Solvency ratio of LIC 2022: 1.85 (March 2021)
  • HDFC life insurance claim settlement ratio: 99.04%
  • Solvency ratio 2022: 1.76.
  • Edelweiss Tokio life insurance claim settlement ratio: 95.82%
  • Solvency ratio 2022: 2.11.

How is Solvency II calculated? ›

For Solvency II, it is a fixed rate of 6% per annum. The product of the cost of capital rate and the capital requirement at each future projection point is then discounted, using risk-free discount rates, to give the overall risk margin.

What is Tier 2 limit in Solvency II? ›

Tier 2 can be up to 50 per cent and tier 3 can be no more than 15 per cent of eligible own funds. If a limit for one tier is exceeded the item may still be capable of being counted in a lower tier.

What is Solvency II large risks? ›

'Large risks' as defined in the Solvency II Directive include: marine, aviation, transport classes and contracts with commercial policyholder of certain size (more than 250 employees, with turnover of more than €12.8m or balance sheet over €6.2m).

What is the difference between Basel II and Solvency II? ›

Concepts behind Basel II/III and Solvency II

2.1. Basel II/III was designed as principle-based but in an environment where there was a low threat of enforcement. Solvency II is also principled based but has an attendant credible threat of enforcement. 2.2.

What are the capital requirements for Solvency II equity? ›

Under Solvency II the standard solvency capital requirement (SCR) for a diversified equity portfolio is 39 percent for stocks listed in developed markets and 49 percent for those listed in emerging markets.

What is the difference between IFRS and Solvency II? ›

Solvency II specifies the risk-free rate as well as liquidity premium, but under IFRS 17, there is no such restriction on liquidity premium. Although the principles-based approach will be adopted in both regulations, Solvency II measures are more prescriptive and comprehensive as compared to IFRS 17.

What are the two types of solvency? ›

Two of the most common coverage solvency ratios are:
  • Interest Coverage = (Earnings Before Interest & Taxes)/Interest Expense.
  • Fixed Charge Coverage = (EBIT + Lease Payments)/(Interest Payments + Lease Payments)
Nov 10, 2022

What are own funds in solvency 2? ›

Own Funds

Under current FCA and PRA rules the margin held is known as 'capital'. Under Solvency II, capital is called 'own funds' and divided into 'basic own funds' (e.g. on balance sheet amounts) and 'ancillary own funds' (such as letters of credit and guarantees) which require supervisory approval.

What is solvency 2 balance sheet? ›

The Solvency II balance sheet is used to determine the net surplus / (deficit) at syndicate level on a Solvency II basis by reporting year of account.

What are the four types of solvency? ›

There are four main types of solvency ratios, as discussed below:
  • Interest Coverage Ratio. This ratio assesses a company's capacity to cover its interest payments, which rises alongside its total debt. ...
  • Debt-to-equity ratio. ...
  • Debt-to-asset ratio. ...
  • Equity Ratio.
Dec 14, 2022

What is solvency ratio for dummies? ›

Summary. The solvency ratio helps us assess a company's ability to meet its long-term financial obligations. To calculate the ratio, divide a company's after-tax net income – and add back depreciation– by the sum of its liabilities (short-term and long-term).

What are the three commonly used measures of solvency? ›

The most common solvency ratios are the debt-to-equity ratio, the debt-to-assets ratio, and and the interest coverage ratio.

What is the basic solvency capital requirement? ›

The solvency capital requirement is the amount of funds that insurance and reinsurance companies are required to hold under the European Union's Solvency II directive in order to have a 99.5% confidence they could survive the most extreme expected losses over the course of a year.

Who has the ultimate responsibility of governance under solvency 2? ›

It is the responsibility of the administrative, management or supervisory body to ensure that the undertaking's organisational structure delivers a system of governance proportionate to the nature, scale and complexity of the risks it faces in its business activities.

What is an example of solvency? ›

For example, a company with a solvency ratio of 1.2 is solvent, while one whose ratio is 0.9 is technically insolvent. One with a ratio of 1.5 is more solvent than one with a ratio of 1.4. A firm's solvency ratio can affect its credit rating – the lower the ratio the worse its rating can become.

How do you know if a company has good solvency? ›

The solvency of a business is assessed by looking at its balance sheet and cash flow statement. The balance sheet of the company provides a summary of all the assets and liabilities held. A company is considered solvent if the realizable value of its assets is greater than its liabilities.

What is a good ratio for liquidity? ›

In short, a “good” liquidity ratio is anything higher than 1. Having said that, a liquidity ratio of 1 is unlikely to prove that your business is worthy of investment. Generally speaking, creditors and investors will look for an accounting liquidity ratio of around 2 or 3.

How is a financial liability valued under Solvency II? ›

Under Solvency II assets and liabilities should be valued at a market-consistent or fair value. The Solvency II rules specifically prohibit certain valuation methods such as historic cost, depreciated cost or amortised cost.

What is a Solvency II firm in the UK? ›

A UK Solvency II firm means a firm: (1) that satisfies the conditions set out in 2.2, or. (2) whose Part 4A permission includes a requirement that it comply with the Solvency II Firms Sector of the PRA Rulebook. 2.2.

Who does Solvency II apply to? ›

Solvency II will apply to most insurers and reinsurers with their head office in the European Union (EU), including mutuals, and companies in run-off unless their annual premium income is less than €5 million.

Does MiFID II still apply to UK? ›

MiFID II regulates the provision of investment services and activities, and related market infrastructure. The EU MiFID II regime has been maintained in the UK post-Brexit, with some adjustments to make the regime operate properly from a UK-only perspective.

What are Solvency II rules? ›

The key features of the Solvency II regulatory framework are: Market consistent: assets and liabilities shall be valued at the amount for which they can be exchanged, transferred or settled in the market. Risk-based: Higher risks will lead to a higher capital requirement to cover for unexpected losses.

Is the UK subject to MiFID? ›

Post-Brexit, the UK has retained any national legislation and regulation that implemented the parts of MiFID that had to be transposed into national law.

How is MiFID II implemented in the UK? ›

The EU MiFID framework was transposed and implemented in the UK by a combination of Handbook rules, Treasury legislation, and directly applicable EU regulations (in the latter case, notably by EU MIFIR (No 600/2014), the MiFID Org Regulation ((EU) 2017/565) and a number of RTSs/ITSs).

Are US firms subject to MiFID II? ›

MiFID II, however, only applies to asset managers that have a physical presence in Europe and that are operating under a MiFID permission and regulated by a European regulator. As a result, US asset managers are not directly regulated by MiFID.

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