In order to protect the insured and to ensure the stability of the financial markets, insurance companies are required to hold a buffer of assets called the solvency margin. This buffer can be defined as the difference between assets and liabilities, as they are specified by the Solvency regulations, currently the Solvency I directives from 1997.
The future Solvency II (Solvency 2) framework will provide an option to use a fundamentally new approach for calculating the required solvency margin. The idea is to let companies construct the models themselves and then ensure, through supervision, that these models are based on sound risk management principles.
The insurance company must be able to explain the internal model to the supervisor, which, in turn, has to understand the model in order to approve it. For companies that lack the ability and resources to develop internal models, a standard approach has been proposed.
Just as with Basel II, which is a regulation for banks covered in Appendix A, Solvency II (Solvency 2) has a wider scope than solely establishing a solvency margin.
First there is a development of earlier regulations that focuses on the establishment of a sufficient solvency margin. An important addition is the concept of risk matching assets and liabilities, also known as Asset-Liability Management (ALM), and encouragement for companies to develop internal models, provided they could be verified. Since the development of internal models may be a heavy burden for smaller companies there will also be a standard approach following the same principles but with a higher margin due to lack of customisation.
The required solvency margin from earlier directives will be split into two levels called the minimum capital requirement (MCR) and the solvency capital requirement (SCR). The MCR will be the absolute minimum level and below this level, the insurance company will face serious legal consequences.
The SCR defines the target capital level. If a company falls below this level some less serious legal action, such as demanding increased frequency of reporting, will be enforced by the supervisor. The SCR can be calculated using a standard approach or an internal model. At the time of writing it is fairly agreed upon that incentives should exist for companies to develop internal models.
The regulations state that technical provisions are the sum of:
– A best estimate of the liabilities, which is the expected present value of future cash flows.
– A risk margin that covers the risk of the future cash flows.
There are also qualitative requirements that defines the framework of supervisory control. Under these requirements falls the supervision of internal risk management processes and aspects of operational risk. This means that the internal models developed will be verified according to principles defined defined by the qualitative requirements.
There is currently a debate whether a standard approach will be sufficient to fulfil the requirements of since a standard approach by definition is not customised to fit the organisation. To be ratified by the supervisor every aspect of a model should reflect the organisation and the model should consider all those risks important to the organisation.
According to many industry specialist the most challenging part of Solvency II will be to ensure the reliability and security of the models.
Organisations must be able to show supervisors that the model accurately reflects the organisation. It is clear that poor data quality has negative effects on the reliability of a model’s results; even if the model itself has been set up correctly, the results may still be incorrect due to the quality of the data.
To meet these challenges within Solvency II (Solvency 2), sufficient data quality and data traceability become very important factors.
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