Solvency II is the updated set of regulatory requirements for insurance firms operating within the European Union. Sophisticated risk managements have been developed since the early 1970s, when the first Solvency structure was introduced. Solvency II introduces a comprehensive framework for risk management for defining required capital levels and to implement procedures to identify, measure, and manage risk levels.
The European Union insurance legislation facilitates the development of a Single Market in insurance services in Europe, while securing an adequate level of consumer protection at the same time. Third-generation Insurance Directives created an “EU passport” (single licence) for insurers. This is based on the concept of minimum harmonisation and mutual recognition.
Many Member States have concluded that the current EU minimum requirements are not sufficient and have implemented their own reforms. This led to a situation where a patchwork of regulatory requirements is present across the EU, hampering the functioning of the Single Market.
Solvency II is based on economic principles for the measurement of assets and liabilities. It is also a risk-based system as risk will be measured on consistent principles which capital requirements will directly depend on. While the Solvency I Directive was aimed at revising and updating the current EU Solvency regime, Solvency II covers a much wider scope.
A solvency capital requirement may have the following purposes:
1. To reduce the risk that an insurer would be unable to meet claims;
2. To reduce the losses suffered by policyholders in the event that a firm is unable to fully meet all claims;
3. To provide early warning to supervisors enabling them to intervene promptly if capital falls below the required level; and
4. To promote confidence in the financial stability of the insurance sector
Solvency II, also often called Basel for insurers, is in ways similar to the banking regulations of Basel II. The proposed Solvency II framework has three main areas:
Pillar 1: consists of the quantitative requirements, such as the amount of capital an insurer should hold
Pillar 2: sets out requirements for the risk management and governance of insurers; also, the effective supervision of insurers
Pillar 3: focuses on disclosure and transparency requirements.