Solvency II: When a 100% Solvency Ratio Is Not Enough
EU insurers are already seeing the emergence of practical issues following the implementation of Solvency II in the EU on 1 January 2016.
Take, for example, the calculation of operational risk capital. Although it is currently capped at 30% of the Solvency Capital Requirement (SCR), most firms are hoping it will be reduced considerably. Across Europe, most national regulators appear willing to accept appropriate insurance policies as part of the capital structure for operational risk.
To date, however, most insurers are focussed on getting the SCR calculation “right”. During the second half of 2016, insurers and their regulators will likely focus on operational risk and the mitigation provided by insurance.
Here in the UK, companies approved to use their internal models for the capital calculation are steadily announcing their Solvency II capital ratios. A major UK company, for example, was recently subjected to very pointed questioning from investment analysts because it held “only” 172% of the SCR, which did not compare well with its life insurance peers.
Critical investment analysts aren’t the only source of upward pressure on regulatory capital. While the Prudential Regulatory Authority (PRA) has not issued official guidance, other national regulators have given their charges to understand that a “mere” 100% of the SCR will result in supervisory intervention. The Dutch national regulator, for example, is requiring standard formula firms to hold 120% of the SCR and not to pay dividends unless they hold 150%.
Why hasn’t the PRA issued guidance?
Perhaps the PRA hasn’t issued guidance because it doesn’t need to: The major rating agencies have indicated that a 100% capital ratio is roughly equivalent to a BBB rating. By contrast, in order to attract business, the absolute minimum requirement in non-life insurance is A- for shorter term business, and A or A+ for longer term business. For life and pension underwriters, the minimum rating requirement starts at A+.
Companies may therefore seek to manage their capital requirement downward, understanding that investors will expect them to set an internal ladder of intervention for their solvency ratio. That might mean that they target a SCR of, say, 180% to 220%, with plans in place should the SCR drop below the floor or exceed the ceiling.
With capital management in mind, companies will focus on the mitigation of operational risk provided by insurance: That mitigation could provide a welcome reduction in the modelled capital requirement and thus serve to flatter SCR numbers.