Pillar 1

QUANTITATIVE MEASUREMENTS (CAPITAL REQUIREMENTS)

The Pillar I requirements of Solvency II set out the quantitative requirements that insurers must satisfy to demonstrate that they have sufficient capital resources.

The intention of the requirements is to bring about a supervisory regime which provides for a risk-sensitive requirement, based on a prospective calculation, to ensure accurate and timely intervention by supervisors (the Solvency Capital Requirement) and a minimum level of security below which the amount of financial resources must not fall (the Minimum Capital Requirement)

Under Pillar 1 firms and groups must maintain:

technical provisions against (re)insurance liabilities;
a minimum capital requirement (MCR); and
a higher solvency capital requirement (SCR).

These requirements must be covered by eligible own funds (i.e. “regulatory capital”).

Technical Provisions
All insurers must establish technical provisions with respect to all of their insurance obligations towards policyholders and beneficiaries under contracts. The value of these technical provisions should correspond to the current amount that the firm would have to pay if they were to transfer their obligations immediately to another insurer.

The Technical Provisions are composed of two elements – a best estimate and a risk margin.

The best estimate should correspond to the probability-weighted average of future cash flows, taking into account the time value of money. The risk margin is the additional amount on top of this that the firm would have to pay if they were to transfer their obligations immediately to another insurer. The risk margin can be calculated by determining the cost of providing an amount of eligible own funds equal to the SCR necessary to support the firm’s insurance obligations over their lifetime.

SCR – the Solvency Capital Requirement
The SCR is calculated on the presumption that the insurer will carry on its business as a going concern. The SCR is intended to cover all existing business as well as the new business expected to be written over the next twelve months.

The SCR corresponds to the Value-at-Risk of the basic own funds of an insurer subject to a confidence level of 99.5% over a one-year holding period. This is described in the preamble to the Directive as “the economic capital to be held by insurance and reinsurance undertakings in order to ensure that ruin occurs no more than once in 200 cases” (Paragraph 37).

The SCR should cover at least the following risks:

Non-life underwriting risk.
Life underwriting risk.
Health underwriting risk.
Market risk.
Credit risk.
Operational risk (including legal risks, but excluding reputational risk and risks arising from strategic decisions).

In order to avoid firms being unduly forced to raise additional capital or sell their investments as a result of unsustained adverse movements in financial markets, the market risk module of the standard formula for the SCR should include a symmetric adjustment mechanism with respect to changes in the level of equity prices. This is to avoid pro-cyclical effects where a slump in values requires firms to make fire sales of their assets, depressing values further.

The SCR may be supplemented by a capital add on at Pillar 2. The SCR may be calculated using a standard formula set out in the Directive or using internal models, subject to regulatory approval.

MCR – the Minimum Capital Requirement
The MCR is a trigger for regulatory intervention. It is set as a minimum level below which the amount of financial resources should not fall. When the amount of basic own funds falls below the MCR, the Directive stipulates that the authorisation of a firm should be withdrawn unless the minimum level can be re-attained in a short period of time.

Firms are required to calculate the MCR at least quarterly and report the results to the Financial Regulator.

The MCR is banded within a ‘corridor’. It cannot be less than 25% of the SCR nor greater than 45% of the SCR.