Risk management under Solvency II: Solvency capital requirements (S. 43-44)

Carlos Montalvo Rebuelta

Introduction

The adoption of the Solvency II Directive on 5 May 2009 by the European Council has been the latest achievement in the very ambitious Solvency II project from the European Commission, to which CEIOPS has been contributing with advice since 2004.

Since its creation in 20032 CEIOPS received three consecutive waves of Call for Advice from the Commission seeking advice from the European insurance supervisory community on the development of a new risk based solvency regime for insurance and reinsurance undertakings.

When setting the founding principles that govern the design of the new solvency framework, the European Commission put forward a three-pillar structure inspired by Basel II: quantitative requirements (Pillar I), supervisory activities (Pillar II) and supervisory reporting and public disclosure (Pillar III).

In its second Call for Advice issued to CEIOPS, the EC has asked CEIOPS to develop advice on the architecture of the risk based capital requirements. The Commission’s Amended Framework for Consultation3 envisaged two main capital requirements under Pillar I: the Solvency Capital Requirement (SCR) and the Minimum Capital Requirement (MCR).

The SCR should deliver a level of capital that enables an insurance undertaking to absorb significant unforeseen losses over a specified time horizon and gives reasonable assurance to policyholders that payments will be made as they fall due.4 The MCR is intended to provide a safety net. This means that, on an ongoing basis, the MCR does not necessarily represent an adequate level of capital. But a level of capital below the MCR is clearly unacceptable, even over the short term. While temporary breaches of the SCR might be tolerated – subject to the prospect of restorative action – a breach of the MCR could not be tolerated.

The total balance sheet approach and the net asset value The quantitative solvency assessment in Solvency II starts from a projection of a simplified balance sheet, consisting of assets, liabilities and available capital (hereafter: own funds). The total balance sheet approach requires that all risks attached to the undertaking’s assets and liabilities are taken into account in the solvency assessment. The level of own funds to be held by the undertaking is measured by the net asset value, ie. the difference between the assets and liabilities of the undertaking.