23 April 2019
The Solvency II supervisory regime has been in effect since 1 January 2016. The aim is to more closely coordinate and harmonise supervision of the insurance industry in European Union member states and thereby establish consistent competitive standards in the insurance sector of the European Single Market.
At the same time insurers are required to report annually on their solvency and financial condition (Solvency and Financial Condition Report, SFCR). On 23 April all companies are publishing their respective SFCR reports on the basis of legal standards. The focus in this context is on the Solvency Capital Requirement (SCR) and the Minimum Capital Requirement (MCR).
Complex mathematical model calculation
The figures are determined using complex mathematical model calculations that seek – based on certain assumptions – to take account of all risks which are relevant to the undertaking and its business model: underwriting risks and operational risks as well as those risks that may arise in connection with the investment of premium income.
The financial regulator and companies alike – as large institutional investors – are therefore focusing more closely on the business conducted by insurance undertakings. In so doing, they can take prompt countermeasures and protect the company – through the prescribed capital buffers – against risks such as large losses caused by natural catastrophes or extreme volatility on equity and bond markets.
What the capital adequacy ratio means
The capital adequacy ratio – or Solvency II ratio – expresses how robustly the capital requirements that may arise upon occurrence of an extreme scenario are covered by the company's own funds. If the Solvency II ratio amounts to at least 100 percent, the insurer's ability to meet its obligations to the fullest extent even in such an exceptional crisis situation is assured. If the capital adequacy ratio is lower, it remains the case that the insurer can in principle fulfil its current and future payment guarantees. The company must then take steps to achieve a capital adequacy ratio of more than 100 percent. This is monitored by the Federal Financial Supervisory Authority (BaFin). In short: a Solvency II ratio of less than 100 percent is not an indication of financial difficulties. It merely means that the safety buffer for extreme crisis scenarios is at times no longer met in full.
The German Actuarial Society urges acaution when it comes to interpreting solvency ratios and warns again rushing to judgement on a company's risk position: "In view of the considerable dependency on movements in the interest rate level, insurers' solvency ratios – and especially those of life insurers – will be subject to sharp fluctuations from year to year", it predicts. Changes in solvency ratios over a longer timeframe must be considered in order to draw serious and reliable conclusions.
Internal models and transitional arrangements
For the purpose of adequately calculating these ratios and determining the risk, the prudential regime of the Federal Financial Supervisory Authority (BaFin) provides for two models between which insurance companies can choose: a standard model and an internal model. The use of an internal model requires special approval from the insurance regulator, which is given only after an intensive review process. The standard model sets out specifications regarding, among other things, solvency capital requirements according to lines of business and risk categories. The internal model replaces these formula-based parameters with principles that reflect the risk profile of diversifying companies with a complex positioning and thus facilitate a more differentiated perspective on their risks. Such a risk profile encompasses, for example, natural catastrophes, risks associated with government bonds, adverse scenarios or movements on equity markets; it should be borne in mind in this regard that the internal model can – depending on the risk module – result in higher or lower risk charges than the standard model. Talanx has been using a partial internal model since the beginning of 2016.
In addition, the regulator provides the option for life insurance companies, in particular, to use transitional arrangements. Especially given the prevailing low interest rate phase and the market distortion brought about by the European Central Bank (ECB), this option serves as an essential tool for measuring liabilities at current market rates and transitioning existing insurance policies to an almost entirely new set of rules as well as for cushioning against the high volatility associated with fair value measurement as at the reporting date.
In common with the majority of German life insurers and large parts of the European life insurance industry, Talanx makes use of these transitional measures. As part of the implementation of Solvency II fully accepted by the regulator, they may only be applied if the BaFin is provided with regular documentary evidence to the effect that these diminishing transitional arrangements will indeed no longer be required by the end of the transitional period at the latest.
With a time-limited transitional period and diminishing effect over 16 years, these arrangements not only accommodate the business model operated by insurers offering long-duration insurance protection (the average term of a policy taken out is around 16 years); they also serve to protect every single insurance policy in the portfolio. Just as is the case with the use of internal models, insurers have the option of whether or not they wish to apply these measures.