IntroductionSolvency II is a directive by the European Union, which was issued in 2009 for purposes of codifying and harmonising insurance regulation within member countries. The main motivation for the directive stemmed from a need to minimise the risk of insolvency among insurance companies in the region. The directive is scheduled to take effect on January 01, 2014. According to Financial Services Authority (FSA) (2012), Solvency II is a major improvement of an earlier directive (Solvency I), which was issued in 1973 for purposes of revising and updating the solvency regime in the EU.
The current direct is cited as being better suited for reducing the risks of an insurer becoming unable to meet claims; reducing the loss-exposure to shareholders; providing early warnings to supervisory agencies regarding trouble insurers; and promoting confidence among the public regarding the insurance sector’s financial stability. The purposes of Solvency IISolvency II adopts a three-pillar approach, which its framers felt were important in meeting the aims of making the insurance sector more stable and risk-averse. The three-pillar approach is illustrated in the figure below, and as can be seen, it proposes the use of ‘quantitative requirements’, ‘qualitative requirements and supervisory review’, and ‘reporting, disclosure and market discipline’ as the three pillars that would anchor the insurance sector.
Figure 1:The three pillars of Solvency IISource: FSA (2012, p. 7). According to Buckham, Wahl and Rose (2010, p. ix), Solvency II targets insurance and reinsurance firms whose turnover exceeds €5 million and through the three pillar approach, holds the promise that the insurance industry will be more transparent in future, and will have a buffer, where interventions can be made to prevent the occurrence of crisis in the industry.
Specifically, it would appear that there is room for regulatory intervention once a problem has been detected, something that would ultimately stem a crisis. The Own Risk and Solvency Assessment (ORSA), which is included in pillar II requires an insurer to assess its solvency needs by considering its risk profile and the strategies it uses to conduct business. According to the Council Directive (2009, act. 45), the ORSA process is set to be assessed regularly by regulators.
The process is illustrated in the figure 2 below: Figure 2: The ORSA ProcessSource: FSA (2012, p. 50). As illustrated in the figure above, the management commences the ORSA process, with the red area codified as ‘ownership’ indicating the management’s responsibility to set general objectives for the report. In the blue area codified as ‘process’, the management identifies the right methodology to use, and identified the roles and priorities that will be met during the process. The greed are codified as ‘report’ signifies the output stage in the process where the management releases a report indicating its business plans and strategies among other things that it is doing or intends to do in order to prevent policyholders from experiencing losses.
While ORSA is a good process on paper, its inclusion in Solvency II has attracted some criticism to the effect that it is a subjective process since the management conducts self-evaluation and makes a report regarding the same. It is thus argued that the process creates the probability of self-bias. Johansen (2011, p. 32) for example observes that the management may be reluctant to reveal critical information thus leading to asymmetrical information between the management of insurance firms and the regulators.
Council Directive (2009, act. 45), specifically observes that the incentive of using ORSA in pillar II is low considering that the process is not directly used to calculate or make adjustments to an insurer’s capital requirements. CEA (2011, p. 10) even argues that ORSA may be perceived as just some additional work especially among small and medium-sized insurers, and as such, the perception of it being a strategic management tool may be eroded.