What is Solvency II?
Solvency II is a Directive in European Union law that codifies and harmonizes the EU insurance regulation. Primarily this concerns the amount of capital that EU insurance companies must hold to reduce the risk of insolvency.
In the United States and the European Union, Solvency II establishes capital requirements for operational, investment, and underwriting risks of insurance companies. Solvency II requires capital buffers above the minimum capital requirement (MCR), called the solvency capital requirement (SCR).
The two approaches an insurance firm can use to calculate the solvency capital requirement (SCR) under Solvency II are:
- Standardized approach.
- Internal models approach.
Analogous to Basel II, the standardized approach to calculating SCR under Solvency II is intended for less sophisticated insurance firms that cannot or do not want to develop their own firm-specific risk measurement model. It is intended to capture the risk profile of the average firm and is more cost-efficient for smaller firms with less fully developed risk management functions.
Internal Models Approach
This approach is similar to the IRB approach under Pillar 1 of Basel II. A VaR is calculated with a one-year time horizon and a 99.5% confidence level. There is a capital charge for the following three types of risk: 1. Underwriting risk: divided into risks arising from life insurance, non-life insurance (such as property and casualty insurance), and health insurance.
Why is Solvency II important?
Improved consumer protection: It will ensure a uniform and enhanced level of policyholder protection across the EU. A more robust system will give policyholders greater confidence in the products of insurers.