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The European Union’s Solvency II directive came into effect in 2016, putting solvency risk at the heart of a harmonised regulatory framework for insurance firms across EU member states.
Solvency II is a far-reaching programme of prudential regulations, which vary in severity depending on the riskiness and diversity of an insurer’s business. Similar to the banking industry’s Basel standards, the Solvency II programme is divided into three areas: Pillar 1 lays out quantitative requirements for the amount of capital an insurer should hold; Pillar 2 covers governance and risk management of insurers; and Pillar 3 addresses transparency, reporting and public disclosure.
There are two capital-holding thresholds at the core of the directive. The solvency capital requirement (SCR) is the amount of funds that insurance and reinsurance companies are required to hold in order to have 99.5% confidence that they could survive the most extreme expected losses over the course of a year. The SCR incorporates risks such as non-life underwriting, life underwriting, health underwriting, market, credit, operational and counterparty risks, and must be recalculated at least once per year.
In addition to this soft limit, firms are also required to adhere to a minimum capital requirement (MCR), that is, the threshold below which local regulators would intervene.
Solvency II was introduced by the EU’s insurance regulator, the European Insurance and Occupational Pensions Authority, but day-to-day oversight of the regulation has been tasked to local regulators. As such, if the capital holding of a (re)insurance company falls below the SCR, the level of intervention will increase progressively, the closer the capital holdings of the firm approach the MCR.
The stated aims of Solvency II are to improve consumer protection, modernise supervision, deepen EU market integration by harmonising supervisory regimes and increase the international competitiveness of EU insurers.
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