Lloyds Solvency II Tutorial

http://www.lloyds.com/The-Market/Operating-at-Lloyds/Solvency-II/Market-Toolsand-Resources/Solvency-II-Online-Tutorial/Tutorial/Welcome

Implementing Solvency II is a priority for Lloyd's. This online tutorial aims to help ensure that staff in the Lloyds market are properly informed about Solvency IIs preparations and its implications. The Society of Lloyds and Lloyds managing agents are investing significant financial and human resources to ensure that Lloyds market is compliant with the new framework from day one. Solvency II will affect everyone working in insurance. It is vital that all insurance practitioners understand key features of this regulatory reform and appreciate the impact that it will have on their day-to-day jobs. We hope that this tutorial will help you to learn more about this subject. This tutorial provides basic information about Solvency II to assist understanding of key features of the reform. It is split into five modules that discuss how the Solvency II framework has evolved, its structure and its implementation at Lloyds. There is a short test at the end of each module. The tutorial will take approximately 30 minutes to complete, but should you need longer to complete it, your PC will remember at what point you left the tutorial and allow you to begin again from that point. It is also worth noting that the tutorial is accredited by the CII for 15 CPD points. Should you require further information or want to learn more about how Solvency II is implemented at Lloyds, please visit www.lloyds.com/solvencyII.

Luke Savage Director, Finance, Risk Management and Operations

What is Solvency II?

An EU legislative programme to be implemented in all 27 Member States, including the UK. Solvency II introduces a new, harmonised EU-wide insurance regulatory regime. The legislation replaces 14 existing EU insurance directives. Solvency II is not just about capital. It is a comprehensive programme of regulatory requirements for insurers, covering authorisation, corporate governance, supervisory reporting, public disclosure and risk assessment and management, as well as solvency and reserving.

What are Solvency IIs objectives?

Improved consumer protection: It will ensure a uniform and enhanced level of policyholder protection across the EU. A more robust system will give policyholders greater confidence in the products of insurers. Modernised supervision: The Supervisory Review Process will shift supervisors focus from compliance monitoring and capital to evaluating insurers risk profiles and the quality of their risk management and governance systems. Deepened EU market integration: All Member States will apply the same rules in a similar way. Increased international competitiveness of EU insurers.

Three pillars will be discussed in more detail in other sections of this tutorial.

What is Solvency I?

Solvency I is the current regulatory regime for EU insurers, introduced in the 1970s. Each EU Member State requires insurers to calculate their solvency margins using methods laid down in Solvency Is rules.

What is new about Solvency II? Solvency II:

Introduces economic risk-based solvency requirements: These requirements are more risk-sensitive and more sophisticated, enabling a better coverage of the risks run by any particular insurer. Is more comprehensive: Solvency II requires insurers to hold capital against a wide range of risks. At the same time, it recognises that capital is not the only (or the best) way to mitigate against failure, so insurers must focus on and devote significant resources to identifying, measuring and managing all the risks they face. Looks forward: Existing solvency requirements are based on historic data. The new rules require insurers to think about future developments, such as new business plans or possible catastrophic events. Insurers must carry out an Own Risk and Solvency Assessment (ORSA) regularly. Requires more public disclosure: Insurers must disclose far more information publicly than at present. This is intended to assist market discipline, as market participants will be better informed about individual insurers. Strengthens the role of the group supervisor: Insurance groups will be supervised by supervisory colleges, headed by group supervisors with specific responsibilities. This will not apply to Lloyds, which is not a group under Solvency II, but is important to many insurers, including some that participate in the Lloyds market.

How is Solvency II structured? The Solvency II legislative programme follows an EU standard framework, which involves legislating and providing guidance at four levels, as explained below: Level 1 Framework Directive The Solvency II Directive sets out key principles and requirements and gives the European Commission powers to adopt implementing measures (Level 2). The Directive was drafted by the Commission and agreed by the European Parliament and the EU Council. Level 2 Implementing Measures The implementing measures are detailed rules that allow Solvency II principles to be put into practice. The main impact of Solvency II on EU insurers is shaped by implementing measures. Level 3 Supervisory Guidelines These are supervisory standards, guidelines and recommendations to enhance convergent and effective application of Solvency II. Unlike levels 1 and 2 they are not mandatory for Member States. Guidelines are drafted by EIOPA. Level 4 Enforcement This covers post-implementation compliance with Solvency II provisions in national laws and regulations.

What is Solvency IIs timeline?

The deadline for Solvency II implementation is 1 January 2013 (subject to legislative confirmation). The scale and intensity of the changes required mean that Lloyds, like most insurers, has had an implementation programme stretching over several years, with many objectives that have to be met before this date.

How does Lloyds influence the development of Solvency II?

Lloyds actively monitors Solvency IIs progress and provides feedback and suggestions for change when appropriate. It maintains close and continuous contact with all key policymakers in EU institutions engaged in the Solvency II debate as well as with HM Treasury and the FSA in the UK.

What is Pillar 1?

Pillar 1 requires insurers to demonstrate that they have adequate financial resources. Insurers must:

Maintain technical provisions (sometimes called reserves) against insurance liabilities. Calculate two solvency requirements: the solvency capital requirement (SCR) and the minimum capital requirement (MCR). Maintain capital (sometimes called eligible own funds) to cover these requirements. Comply with Solvency IIs rules on investment.

What is the Minimum Capital Requirement (MCR)?

The MCR is the minimum level of capital set for an insurer under Solvency II. It represents a level of capital below which policyholders and beneficiaries are exposed to an unacceptable level of risk. An insurer must maintain its financial resources above the level of the MCR. If it does not do so, then immediate supervisory action is triggered, possibly including closure of the business.

What is the Solvency Capital Requirement (SCR)?

The SCR is the higher level of regulatory capital set for an insurer under Solvency II. An insurers capital should at least equal its SCR. The SCR corresponds to an insurers Value at Risk calibrated to a 99.5% confidence level over a one year timeframe. This means that it is the level of capital calculated to cover the worst loss that one would expect to occur in a single year over the next two hundred years. Put another way, the insurer should have a 99.5% chance that it will be in a position to meet its obligations to policyholders over the next 12 months. If an insurers available resources fall below its SCR, then its national supervisor must ensure that the insurer takes action to restore its finances to the SCR level as soon as possible. If the insurers financial situation continues to deteriorate, the level of supervisory intervention is progressively intensified. The aim of this supervisory ladder is to deal with a failing insurer before there is a serious threat to policyholders interests. The insurer does not have to stop trading. The SCR may be calculated using:

the Solvency II standard formula; or

an internal model. Insurers may use a mixture of the two, if they use a partial internal model.

What is the standard formula?

The standard formula is the method set out in Solvency II for the calculation of an insurers SCR, where the insurer does not have an approved internal model. The standard formula is intended to include the full range of risks likely to face an insurer. It contains the following risk modules:

Underwriting risk Market risk

The risk of loss due to inadequate pricing and provisioning assumptions.

The risk of loss from fluctuations in the level and in the volatility of market prices of assets and liabilities. The risk of loss from fluctuations in the credit standing of issuers of securities, counterparties and any debtors to which insurers are exposed. The risk of loss arising from failed or inadequate internal processes, personnel or systems or from internal events.

Credit risk

Operational risk

What is an internal model?

An internal model is a risk management system used by an insurer to analyse its overall risk position, to quantify risks and to determine the capital required to meet those risks. An insurer must seek its national supervisors approval if it wishes to use its own internal model to calculate its SCR (instead of the standard formula). An insurer may use a partial internal model to calculate the SCR for one or more risk modules and use the standard formula for other risk modules. Like a full internal model, a partial internal model requires supervisory approval. Because an internal model is designed to reflect an insurers unique risk profile, it is likely to calculate an SCR that reflects more closely than the standard formula the actual risks facing the insurer.

What is Pillar 2? Pillar 2 deals with an insurers governance, internal controls and risk management processes. It also covers the approach to supervisory review. Governance requirements: An insurer must:

Have in place an effective system of governance which provides for sound and prudent management of the business. Be run by persons who are fit (with adequate professional qualifications, knowledge and experience) and proper (of good repute and integrity). Have in place an efficient risk management system. Conduct an own risk and solvency assessment (ORSA). Have in place an effective internal control system, internal audit function and actuarial function.

The Supervisory Review Process (SRP): A supervisor must review and evaluate an insurers strategies, processes and reporting procedures, including its system of governance, on a regular basis. Following an SRP, the supervisor can, in defined circumstances, set a capital add-on for an insurer, if it thinks that this is necessary.

What is an Own Risk and Solvency Assessment (ORSA)?

An ORSA is the processes and procedures employed by an insurer to identify, assess, manage and report the risks it may face and to determine the funds necessary to ensure that its overall solvency needs are met at all times. The ORSA must consider the business strategy, how the strategy aligns to risk appetite and the current risk profile (all key risks facing the insurer) and assess the level of capital to run the business (economic capital) over their planning period (e.g. over a three to five year period), as well as the SCR and the adequacy of own funds. Every insurer is required to carry out an ORSA on a regular basis. This is not the same as the internal model: its scope is larger. When producing the ORSA every insurer will have to establish an ORSA policy, record of each ORSA, internal documentation, a supervisor document and a publicly disclosed document.

What is Pillar 3? Pillar 3 includes requirements for public disclosure and reporting to national supervisors. An insurer must prepare:

A Solvency and Financial Condition Report (SFCR) This a publicly-available document, published annually. It must contain detailed information about the insurer, including descriptions of its business, performance, governance, risk categories and capital management. A Regular Supervisory Report (RSR) - This contains all the information necessary for the purposes of supervision. An insurer must file reports with supervisors annually and quarterly. Implementing measures will set out in detail the information that must be contained in the SFCR and RSR.

How does Solvency II apply to Lloyds?

Solvency II applies to Lloyds members collectively as a single entity: the association of underwriters known as Lloyds. The aim is therefore to apply to the FSA for approval of a single Lloyds internal model under Solvency II (internal models are covered by module 3).

How does Solvency II apply to Lloyds managing agents?

Although the Solvency II Directive does not apply to managing agents directly, Lloyds and the FSA expect managing agents to comply with Solvency II standards. Application of Solvency II to managing agents reflects UK financial regulatory requirements and the structure of Lloyds itself. Lloyds requires managing agents to develop internal models for the syndicates they manage. These syndicate internal models are important elements in Lloyds internal model. Lloyds and the FSA are overseeing the process by which managing agents develop syndicate internal models.

How is Solvency II being implemented at Lloyds?

Successful implementation of Solvency II across the Lloyds market is a priority for Lloyds. It has an implementation programme with six defined workstreams. Luke Savage (Director, Finance, Risk Management & Operations) has overall responsibility for Lloyds implementation programme. Progress is assessed against detailed work programmes. A project support team monitors developments and coordinates the overall programme. Progress is facilitated by close cooperation between Lloyds and Lloyds Market Association (LMA).

What are the Lloyds implementation programme workstreams? Implementation at Society level Implementation at syndicate level Capital levels Lloyds risk management and governance frameworks are enhanced, in line with Solvency II requirements. Each syndicates internal model and each managing agents governance and risk management framework achieves Solvency II standards. The appropriate calibration of technical provisions and capital requirements is achieved given Lloyds underwriting profile and structure. Lloyds secures FSA approval of a single internal model (syndicate-level models are integral components) for capital setting under Solvency II. Lobbying within the EU and UK ensures that Solvency IIs application most appropriately reflects Lloyds structure; communication about the programme supports the achievement of other programme objectives.

Internal model approval Lobbying and communication

Reporting and disclosure

Lloyds meets its Solvency II reporting and disclosure regulatory obligations.

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End of Tutorial

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