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Regulatory frameworks for capital adequacy for insurance firms were first introduced in the early 1970’s and since then more complex and sophisticated risk management systems were gradually brought in, the latest of which being the European Commission’s regulatory directive Solvency II. The concept of capital adequacy is based on solvency margins; the amount of regulatory capital an insurance firm is obliged to hold against unforeseen events to protect policyholders, reducing the likelihood of consumer loss or market disruption. In the 1990’s it was acknowledged in the third generation of EU Insurance Directives (which established a license for insurers based on single requirements) that the rules on solvency margins required significant amendment. Solvency I was a limited reform agreed by the European Parliament in 2002 following the Commissions initial review.
Consolidation of regulations across Europe
Solvency I was considered inadequate as it was interpreted and implemented in different ways by insurance companies in each country, furthermore many member states considered the EU minimum requirements as insufficient and initiated their own reforms, leading to a ‘patchwork’ of local standards which hindered the development of a single EU market for insurance services. Solvency II has been a more fundamental review of solvency margin requirements and risk management standards putting in place a comprehensive EU-wide framework for the insurance industry to replace Solvency I.
The two primary aims of Solvency II were to consolidate regulations for insurance firms across the EU into a single standard making business much easier between member states, whilst ensuring adequate levels of consumer protection. It was the largest ever initiative to draw all EU insurance firms under a single regulatory regime governing what constitutes an acceptable level for solvency margins. Solvency II is often referred to as ‘Basel for insurers’ as it mirrors the Basel II requirements that unite banking regulations across the EU. Solvency II requires firms to measure their assets and liabilities consistently across the European market against risk-sensitive capital requirements which are far stricter than other regulatory regimes in place for insurance firms worldwide.
Overall the tight regulations on capital greatly reduced the risk that insurers would be unable to meet claims, providing an ‘early warning system’ for insurance supervisors if solvency margins fell below a certain threshold, increase market transparency and bolster consumer confidence in the financial security of the insurance industry. Solvency II is an integrated regulatory framework consisting of three main pillars. Pillar 1 (Quantitative Requirements) sets out a firm’s minimum solvency capital requirements or margin which may be calculated using either a standard formula or if it meets supervisory approval, an internal model based on the risks faced by the individual firm. Pillar 2 (Qualitative Requirements) outlines the regulations for evaluating the adequacy of governance and risk management systems and processes along with measures for effective supervision of the insurance industry.
Firms have to ensure that controls are in place to maintain the solvency margin calculated as necessary and supervisors will assess the need of firms to hold additional capital to offset risks not covered sufficiently by the quantitative requirements of Pillar 1. Pillar 3 (Disclosure Requirements) ensures transparency and requires firms to disclose publically details of their specific risks, capital held and risk management processes relevant to market participants, the aim of these disclosures is to enhance market discipline.
Solvency II has brought major changes to regulation of the UK insurance industry
Firms needed to assess where they would be placed in the new competitive European landscape that Solvency II created, assess whether under the new stricter controls on solvency margins the capital they held would be adequate and also whether they wished to make valuations based on the standard formula or adopt an authorized internal model.
In general the insurance sector stood up well to the 2008 financial crisis however it did still highlight the urgent need for tighter regulation, transparency and stricter risk management across the financial services industry. Standard & Poor's sometimes controversial report on the new Directive: "One in Four of Europe's Insurers Could Face Major Strategic Decisions Under Solvency II" concluded that Solvency II would cause profound changes across the European insurance sector and felt that the greater harmonization across the markets would lead to accelerated consolidation within the EU. Competition between insurers will likely increase as the playing field is leveled-out by tighter controls and greater transparency, competitiveness of European insurers with those outside of the EU should improve significantly under what will be the strictest regulations in force worldwide, however non-EU insurers operating within the EU could be pushed out by the new regulations.
The long-term effects of Solvency II with its tighter controls around capital and risk management has had a positive impact greatly improving the robustness of the European insurance industry, giving greater protection and increasing confidence amongst policyholders, easing the EU insurance trade and increasing market transparency. Insurance firms however can easily run into difficulty if they have not carefully taken all risk into account and maintained adequate capital, Short term instability and weeding out insurance companies which were already weak, with inadequate capital or insufficiently prepared for the new regime has given way to a more level playing field, enhanced business relations between European firms and increased European competitiveness on the world stage.
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