June 2015
The Bank of England (BoE)’s Prudential Policy Directorate has set out penalties for firms that fail to meet the Solvency II capital standards.
According to a report issued last week (8 June), the BoE said that the two capital requirements introduced by Solvency II would act as trigger points in the regime’s “supervisory ladder of intervention”.
The solvency capital requirement (SCR) is the quantity of capital intended to provide protection against unexpected losses over the following year, up to the statistical level of a 1-in-200-year event.
Meanwhile, the minimum capital requirement (MCR) denotes the level below which policyholders would be exposed to an unacceptable level of risk.
If a firm breached the SCR, it would be required to develop a plan “to restore its capital position and/or reduce its risk profile”, the BoE said, adding that falling below the SCR would represent an intervention point for supervisors to take action.
In addition, distributions to investors would either be cancelled or deferred.
Should a firm breach the MCR, regulatory action would be taken and the company would be required to submit a plan for approval explaining how it planned to restore capital above the MCR within three months, the BoE said.
If the firm was unable to do so, its authorisation may be withdrawn.
Insurers are currently preparing for the full implementation of Solvency II on 1 January 2016.
Although companies are expected to be compliant from this point, measures have been put in place that allow firms a transitional period of up to 10 years to replace capital instruments that are not compliant with Solvency II requirements.
The report also warned firms that they should recognise the limitations of internal models, which can be used to calculate the SCR in a way that takes into account the specific risk profile of the insurer.
“It is important that firms do not place undue reliance on internal models or treat them as ‘black boxes’ and simply take model outputs at face value,” the report noted.
“As with all models, the output of an internal model relies on the quality and quantity of input data and the design and calibration of the model itself.”
It explained that if a firm’s risk profile significantly deviated from the assumptions underpinning the calculation of the SCR by an internal model, supervisors could demand that the company change the model.
“In exceptional cases, the Prudential Regulation Authority [PRA] will be able to impose a ‘capital add-on’ that would increase the SCR to the quantity of capital that would reflect the true risk profile.”
In addition, the report highlighted areas that Solvency II did not directly address, such as the resolution of insurers and the capital treatment of insurers’ non-traditional and non-insurance activities.
These activities often involve the sale of products that may expose an insurer to risks not generally associated with traditional insurance business, such as liquidity risk.
“Although Solvency II is a step forward, there are policy areas that need further thought and development,” the report concluded.
