Solvency ii Study Notes

1. Study Notes Solvency II

2. 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

3. 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.

4. 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.

5. Aims of Solvency II (cont.) 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.

6. Aims of Solvency II (cont.) 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

7. The three pillars Similar to the banking industrys 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

8. 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

9. Pillar I: Capital Requirements (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

10. Pillar I: Capital Requirements (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 insurers 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

11. Pillar I: Capital Requirements (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 insurers SCR limit Above 45% insurers SCR limit

12. 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 firms 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

13. 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 companys 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.

14. 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 insurers 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.

15. Pillar III: Disclosure Pillar III is similar to that of Pillar I as it refers to quantitative information as opposed to Pillar IIs 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?

16. 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 its prudent person principle approach

17. Private Equity Investing Facet (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

18. The Impact of Solvency II on the Private Equity Investing Facet (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.

19. Non-EU parent companies with European subsidiaries firms operating within Europe will be required to display their groups 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 groups supervisory requirements ito the Solvency II directive.

20. 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.

21. 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

22. 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

23. 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 portfolios holdings and risk exposure hedge funds are classified as other equities in the standard formula and are thus subjected to a 49% capital

24. Implication of Solvency II for the 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

25. Implication of Solvency II for the 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

26. 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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