Framework of solvency and supervisory standards for insurers and reinsurers across the EU market
The Solvency II Directive (2009/138/EC) came into force on 1 January 2016 providing the risk-based supervisory framework for insurance sector in the European Union (EU). The Solvency II framework sets out important information and regulatory requirements for insurance and reinsurance firms and groups, covering authorisation, financial resources, governance and accountability, risk assessment and management, supervision, reporting and public disclosure, and more.
The aim is to reduce an insurer’s risk of insolvency. At the same time, the Directive serves to harmonise supervisory law in the European Single Market.
Following the United Kingdom’s (UK) withdrawal from the EU, the UK Government worked with regulators to adapt the UK’s financial services regulatory framework to the UK’s new position outside the EU. The revised UK prudential regime for insurers is commonly referred to as ‘Solvency UK’. However, for clarity and consistency of its policy materials, the Prudential Regulation Authority (PRA) will continue using the term ‘Solvency II’ until all references are updated across relevant materials.
The Solvency II regime introduces for the first time a harmonised, sound and robust prudential framework for insurance and reinsurance undertakings in the EU. Its primary function is to ensure the financial stability and solvency of insurance companies, thereby safeguarding policyholders and maintaining confidence in the financial system. Solvency II follows a risk-based approach, assessing the 'overall solvency' of firms through both quantitative and qualitative measures.
The framework consists mainly of the:
Solvency II (Directive 2009/138/EC) - as amended by Directive 2014/51/EU ('Omnibus II') - replaces 14 existing directives commonly known as 'Solvency I'.
This regime replaced the previous Solvency I framework to address its limitations, particularly the need for a more dynamic, risk-based approach that better reflects the complexities of modern insurance markets. Today, the framework affects every aspect of the modern insurance business: pricing, underwriting, assessment, risk management, asset management, internal and external reporting, and more.
As a result, Solvency II has strengthened the insurance regulatory framework by introducing rigorous capital requirements and a detailed methodology for calculating technical provisions, including the new Risk Margin component.
Under Solvency II, the Solvency Capital Requirement (SCR) is calibrated to ensure that insurers can meet their obligations over the next 12 months with a probability of at least 99.5%. This means that insurers must hold sufficient capital to withstand significant adverse events, reflecting a more robust approach compared to previous regulations. The SCR can be calculated using either a standardised formula provided by regulators, or an internal model developed by the insurer, subject to regulatory approval.
A notable enhancement in Solvency II is the refined approach to calculating technical provisions, which are now defined as the sum of the Best Estimate (BE) and the Risk Margin (RM).
Best Estimate (BE): This represents the probability-weighted average of future cash flows, discounted to present value, considering all possible scenarios. It includes both claims provisions (for events that have already occurred) and premium provisions (for future exposures from existing policies). The BE aims to provide an unbiased estimate of the insurer's liabilities without any additional prudence margins.
Risk Margin (RM): Introduced as a new component under Solvency II, the RM ensures that the value of technical provisions is equivalent to the amount another insurer would require to take over and meet the insurance obligations. It accounts for the cost of holding capital to support non-hedgeable risks over the lifetime of the insurance obligations. The inclusion of the RM aligns the valuation of liabilities more closely with market conditions, promoting a market-consistent valuation framework.
This approach enhances the accuracy and transparency of insurers' financial positions, ensuring that technical provisions are sufficient to cover expected future liabilities and the associated risks.
The Solvency II regime is principles-based and intended to achieve a high degree of convergence in regulatory standards across Europe, although some flexibility is allowed to each country in adapting it to their own market.
The risk-focused and forward-looking approach of the Solvency II Directive represents a fundamental shift in how insurance company capital requirements are calculated and modifies the supervisory measures and tools available.
Solvency II is more than just a capital framework. It is a comprehensive regulatory programme for insurers, encompassing authorisation, corporate governance, supervisory reporting, public disclosure, risk assessment and management, as well as solvency and reserving.
The Solvency II framework is divided into three areas, known as pillars:
Two thresholds:
- Solvency Capital Requirement (SCR)
- Minimum Capital Requirement (MCR).
SCR is calculated using either a standard formula or, with regulatory approval, an internal model.
MCR is calculated as a linear function of specified variables: it cannot fall below 25%, or exceed 45% of an insurer's SCR.
Harmonised standards for the valuation of assets and liabilities, and capital requirements.
Effective risk management system.
Corporate governance and safety measures.
Own Risk & Solvency Assessment (ORSA).
Supervisory review & intervention.
Pillar 3: Supervisory Reporting and Public Disclosure
Insurers required to publish details of the risks facing them, capital adequacy and risk management.
Transparency and open information are intended to assist market forces in imposing greater discipline on the industry.
Together, these three pillars create a robust and balanced regulatory framework that not only safeguards policyholders but also promotes financial stability across the insurance sector. By integrating quantitative measures, governance standards, and transparency requirements, Solvency II ensures that insurers remain resilient in the face of evolving risks while fostering trust among regulators, investors, and the public.
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