Capital Requirements

Capital Requirements are the most obvious area where Solvency II will have the most impact. The current EC system calculates capital requirements on Asset values, Insurance Provisions and Net Written Premium. The Capital requirements under Solvency II will consist of two levels, the Minimum Capital Requirement (MCR) and the Solvency Capital Requirement (SCR).

Key

1: Technical provisions to match insurers' liabilities; (Undiscounted in Solvency I – Discounted in Solvency II)
1a: Best Estimate of dsicounted liabilities
1b: Margin set in technical provisions
2: Regulatory capital requirements
3: Capital held in excess of regulatory capital requirements

Solvency I

Minimum Guarantee Fund (MGF) - the absolute minimum capital required
Required Minimum Margin (RMM) - the main solvency requirement

Solvency II

Minimum Capital requirement (MCR) - the minimum level of regulatory capital
Solvency Capital Requirement (SCR) - the risk based level of regulatory capital
Adjusted SCR - SCR level which includes any supplementary capital requirement determined through the Pillar 2 Supervisory review
Internal Risk and Capital Assessment (IRCA) - the management's internal estimate of capital need

MCR – Minimum Capital Requirement:

As the title suggests this is the minimum level of capital a firm must hold; if a firm breaches this level ultimate supervisory action will be triggered. The exact specification of the MCR is currently undecided. Further information can be found under the section ‘MCR’.

SCR – Solvency Capital Requirement:

This can be viewed somewhat as a ‘buffer’ above the MCR which although can be breached, the severity of the breach will provoke some level of intervention by supervisors. The ladder of intervention is used by supervisors to act upon these breaches. The SCR can be calculated via two methods; a standard formula or an approved internal model which captures the risk profile of the undertaking. There can also be partial internal models, blending come elements of the standard formula and internal models together.

Adjusted SCR:

This is the SCR plus any capital add-ons to account for risks which is not fully accounted for in the SCR. These add-ons can be imposed by the supervisor and results in a higher capital requirement for deficiencies in the risk profile of an undertakings business for the purposes of calculating the SCR.

Solvency II is aiming for an altogether more risk based system which, which provides a cushion and early supervisory warning to warn against difficulties. This has been dubbed the ‘supervisory ladder of intervention’. Further information can be found under the section ‘SCR’

Ladder of Intervention:

The supervisory ladder of intervention denotes the action which a supervisor will take if certain capital thresholds are breached. The following table (Table 1) summarises this so-called ‘ladder’. It is therefore imperative that the SCR and MCR work together so that this ‘ladder’ can be maintained.

When developing these capital requirements it is necessary to assess the valuation of assets and liabilities. Where possible this has to be done on a market consistent (i.e. in line with that of a deep and liquid market’s) pricing basis. Where this is not possible a Best Estimate + Risk Margin methodology is used to value these assets. The method of assessing the risk margin has been somewhat open to debate.

Table 1: Supervisory Ladder of Intervention

	Additional Reporting	Financial Recovery Plan	Closure to New Business	Authorisation Withdrawn
No Breach (Adequate Capital)	Not Required	Not Required	Not Required	Not Required
Breach of Adjusted SCR	Required	Possible	Not Required	Not Required
Breach of SCR	Required	Required	Possible	Not Required
Breach of MCR	Required	Required	Required	Possible

Solvency II intends for institutions’ capital to be equivalent to at least a BBB Credit rating and thus should be able to cope with a one-in-two hundred year event. Consequently it is anticipated that a 99.5% Value at Risk (VaR) distribution will be used to calibrate the SCR.

Value at Risk is the probability distribution used to calculate risk of default on the target level of Capital. By being set at a 99.5% confidence level, the probability of default is equivalent to a 1-in-200 year event.

Tiered Capital:

Capital will be tiered according to its degree of loss absorbency. Limitations will be placed upon the amount of each capital which can be held. For further information see the section under ‘Own Funds’

Contact Secretariat: Richard Camp

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