Solvency 2 explained

Published: 19th March 2010
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In a nutshell, solvency 2 is the replacement for the existing solvency 1 review system for insurance businesses operating in the European Union.

Solvency 2 is described by the financial services authority as a "fundamental review of the capital adequacy regime for the European insurance industry". It will apply to all insurance and reinsurance firms whose gross premium income exceeds 5m Euros.

Currently, insurance companies are operating under solvency one regulation and will do for some time. However, by the 31st of October 2012, any insurance firm working in the EU will have to comply with new legislation. In the intervening time, as the different national governments develop their individual implementations, companies can prepare for the new scheme based on the existing information available from the FSA and the EU.

The central aim of this new policy is to strengthen the capital adequacy regime to reduce the possibility of consumer loss or market disruption in insurance. Although currently under development, it can be broken down into three 'pillars'.

Pillar one - or "demonstrating adequate financial resources" as described on the FSA information page, will apply to all firms and considers key quantitative requirements. Effectively, it sets out the minimum capital requirements that firms will need to meet in terms of insurance, credit, market and operational risk.

Pillar two - "demonstrating an adequate system of governance" is effectively a supervisory review process. Solvency 2 supervisors will evaluate effective risk management systems and prospective risk identification for a firm. Supervisors may decide that a firm needs to hold additional capital against risks that weren't covered under pillar one.

Pillar three - "public disclosure and regulatory reporting requirements" is the final element of the new regime. This will require firms to publish some information on their risks, capital and risk management systems. The aim of this step is to harness and reinforce market discipline among insurance firms in the EU, providing clearer data for future legislation.

Given the complexity of the new system and its differences from the current regime getting a head start on Solvency 2 would be a valuable form of insurance for the industry.

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