2016 Solvency II General Insurance

SOLVENCY II – GENERAL INSURANCE

1 Solvency II
1.1 Background to development of Solvency II
During the development of Solvency II key objectives were maintained: to increase the
level of harmonisation of solvency regulation across Europe, to introduce capital
requirements that are more sensitive to the levels of risk being undertaken, and to provide
appropriate incentives for good risk management.

1.2 Introduction to Solvency II

Solvency II has reformed the solvency requirements for life and non-life insurance
undertakings, thus improving policyholder security. Solvency II has superseded the
previous Insurance Directives and the Reinsurance Directive.

Significant delays arose in the implementation of Solvency II. UK domiciled insurance

and reinsurance companies are now governed by Solvency II which came into effect on
1 January 2016, implemented by the PRA. Note that some elements of the Directive are
subject to transitional measures, i.e., a gradual introduction.

Solvency II is a risk-based approach to prudential requirements which brings

harmonisation at EEA level.

The Solvency II Directive applies to all insurance and reinsurance companies with gross
premium income exceeding €5 million or gross technical provisions in excess of €25
million; member states have the option to impose lower limits.

EIOPA (the European Insurance and Occupational Pensions Authority, one of the EU’s
three financial supervisory bodies and which was previously known as CEIOPS) had
provided technical advice and support to the European Commission for the development
of the delegated acts (which provide more detailed implementing guidance than the over-
arching Directive) and was responsible for producing some of the technical standards and
additional guidance.

1.2.1 Comments on this document

All information included in this Unit is current as at the time of writing (April 2016), but it
should be borne in mind that the Solvency II regulations continue to evolve.

The Solvency II Directive applies to all EU insurance and reinsurance companies with
gross premium income exceeding €5 million or gross technical provisions in excess of €25
million. It became operative from 1 January 2016.

Transitional arrangements are available for some aspects (e.g. technical provisions, risk-
free interest rates, continued use of ICA), for a defined period (up to 16 years). The

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intention is to avoid unnecessary disruption of markets and availability of insurance

products. However, UK firms have had to make formal applications to the PRA to be
permitted to use the transitional arrangements.

This section focuses on the Solvency II requirements for non-life insurance and
reinsurance undertakings. There are separate (but broadly equivalent) requirements for
life and health insurance business.

1.3 Pillars 1, 2 and 3

The Solvency II framework consists of three “pillars”.

1) Pillar 1 comprises quantitative requirements including risk-based capital requirements

that firms will be required to meet with assets and liabilities valued on a market
consistent basis. In Pillar 1 the new solvency system contains two capital
requirements defining the upper and lower end of a ladder of supervisory intervention.
The Solvency Capital Requirement (SCR) is the level above which there is no
supervisory intervention for financial reasons. The Minimum Capital Requirement
(MCR) is the level below which the supervisor’s strongest actions are taken (e.g.
removal of the insurer’s authorisation). The SCR may be calculated using a standard
formula or, subject to prior supervisory approval, an insurer’s internal model, or
combination of the two. The MCR is calculated using a linear formula and must fall
between 25% and 45% of the SCR. Capital add-ons may be imposed by the supervisor
in exceptional circumstances where it concludes that the risk profile of the insurer
deviates significantly from the assumptions underlying the SCR or the system of
governance deviates significantly from the standards required. Supervisor-imposed
add-ons increase the SCR.

2) Pillar 2 comprises qualitative requirements focusing on governance, risk management

and required functions and includes the supervisory review process. Insurers are
required to carry out an Own Risk and Solvency Assessment (ORSA) and this is
required to be reviewed by the supervisor. Pillar 2 includes “prudent persons”
investment principles. Supervisors can also impose capital additions for governance
failings.

3) Pillar 3 comprises reporting and disclosure requirements including a public Solvency

and Financial Condition Report (SFCR) and a private Regulatory Supervisory Report
(RSR). The aim of public disclosures is to harness market discipline by requiring
firms to publish certain details of their risks, capital and risk management.

This combination of minimum capital standards, qualitative risk management

requirements, a well-defined and rigorous review process of companies’ solvency by
supervisors and prescribed disclosures to supervisors, policyholders and investors has been
designed to deliver a more modern and secure prudential regulatory system.

The three Pillars are considered in more detail below.

Solvency II requirements apply at both individual insurer and group level, and provision is
made for supervisory co-operation among jurisdictions through supervisory colleges.

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1.4 Regulatory framework

The Solvency II Framework Directive (2009/138/EC) was published in the European
Journal on 17 December 2009 and was amended by the Omnibus II Directive on 11 March
2014.

Detailed requirements not included in the Framework Directive are set out in the
Delegated Acts and implementing technical standards, and these are further supported by
level 3 guidance from EIOPA and enforcement by the European Commission.

1.5 The Solvency II balance sheet

The Solvency II balance sheet is summarised in the following diagram:

Inadmissible assets/
ineligible capital
Tier 3 Free
Capital
Eligible Tier 2
capital Solvency Capital
SCR Requirement
Tier 1 Minimum Capital
MCR
Requirement
Risk margin
MV liabilities
(hedgeable)

(CoC approach)
Technical
provisions
Best estimate
liability (non-
hedgeable)
Other
liabilities

1.5.1 Valuation of assets

Assets are to be valued at the amount for which they could be exchanged between
knowledgeable willing parties in an arm’s length transaction.

The use of quoted market prices is the default valuation approach.

Where quoted market prices are not available, mark to model valuation approaches should
be used.

Recoveries expected from reinsurance are shown as an asset on the balance sheet, rather
than as a reduction in gross liabilities. Such recoveries must be adjusted to allow for the
best estimate of expected losses due to the default of the reinsurer.

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1.5.2 Eligible capital

The phrase “own funds” refers to assets in excess of technical provisions and subordinated
liabilities. These are split into basic and ancillary own funds, which are then tiered based
on specific criteria.

Basic own funds is broadly capital that already exists within the insurer. Ancillary own
funds is capital that may be called upon in certain adverse circumstances, but which does
not currently exist within the insurer (e.g. unpaid share capital).

The capital is tiered based on its loss absorbency and permanency. Tier 1 capital is the
most loss absorbent and permanent form of capital (e.g. paid up ordinary share capital);
Tier 3 the least (e.g. subordinated debt).

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The following table summarises the principal criteria to be used in the tiering of the basic
own funds, and illustrates the different characteristics of Tier 1, Tier 2 and Tier 3 capital:

Criteria Tier 1 Tier 2 Tier 3

Subordination Must rank after the claims Must rank after the Must rank after the
of all policyholders, claims of all claims of all
beneficiaries and non- policyholders, policyholders,
subordinated creditors. beneficiaries and non- beneficiaries and non-
subordinated creditors. subordinated creditors.
Loss absorbency Immediately available to Not necessarily Should not cause or
absorb losses. immediately available to accelerate insolvency.
absorb losses.
Absorbs losses at least on
SCR breaches. Should not cause or
accelerate insolvency.
Should not cause or
accelerate insolvency.
Sufficient duration Undated or of the same Undated or minimum 10 Undated or minimum 5
duration as the years maturity at issue. years maturity at issue.
undertaking. Contractually locked in Contractually locked in
Contractually locked in or or replaced at least or replaced at least
replaced at least equivalently on breach equivalently on breach
equivalently on breach of of SCR. of SCR.
SCR.
Free from incentives to Only redeemable at the Only redeemable at the Only redeemable at the
redeem option of the insurer or option of the insurer or option of the insurer or
reinsurance undertaking. reinsurance undertaking; reinsurance
limited incentives to undertaking; limited
redeem are permissible incentives to redeem
after 10 years from date are permissible
of issuance.
No mandatory fixed Suspension of redemption Suspension of Suspension of
charges provided and redemption provided and redemption provided in
coupons/dividends can be coupons/dividends can case of breach of SCR.
cancelled in case of be cancelled in case of Deferral of
breach of SCR. breach of SCR. coupons/dividends on
breach of MCR.
No encumbrances Unconnected with other Unconnected with other Unconnected with
transactions and no transactions and no other transactions and
restrictions, charges or restrictions, charges or no restrictions, charges
guarantees. guarantees. or guarantees.

Restrictions are placed on the quality of capital that can be used to cover the MCR and
SCR. It is proposed that the MCR and SCR must be covered by eligible capital as follows:

 80% of the MCR must be covered by tier 1 capital

 The SCR must be covered by the combination of tier 1, tier 2 and tier 3 capital

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 50% of the SCR must be covered by tier 1 capital

 No more than 15% of the SCR may be covered by tier 3 capital.

1.5.3 Technical provisions

Technical provisions should represent the amount that the insurance company would have
to pay in order to transfer its obligations immediately to another insurance company.

Technical provisions comprise premium provisions and claims provisions and are equal to
the sum of a best estimate and a risk margin.

1.5.4 Best estimate

The best estimate is the probability-weighted average of future cash-flows, discounted to

allow for the time value of money.

All assumptions used should be best estimate assumptions, with no prudential margins.
Insurance companies must take into account all relevant available data, both internal and
external, when arriving at assumptions that best reflect the characteristics of the
underlying insurance portfolio.

For each currency and maturity, the basic risk-free interest rates used to discount future
cash-flows are derived from interest rate swap rates, adjusted for credit risk.

1.5.5 Risk margin

The risk margin is intended to ensure that the value of the technical provisions is
equivalent to the amount that insurance and reinsurance undertakings would be expected
to require in order to take over and meet the insurance and reinsurance obligations. It is
calculated by estimating the cost of capital equal to the SCR necessary to support the
insurance and reinsurance obligations over their lifetime in respect of those risks which
cannot be hedged – these include underwriting risk, reinsurance credit risk, operational
risk and “unavoidable market risk”.

The risk margin is calculated by the following steps:

 Estimating the future development of SCRs into the future

 Multiplying the future development of SCRs by a cost of capital, currently specified to

be 6% per annum

 Discounting the resulting costs of capital, using relevant risk-free interest rate term
structures provided by EIOPA.

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I General Insurance

The methhod of calcullation of the risk margin is illustrated in the follow

wing diagram
m:

The calcuulation of thee risk marginn using this methodology

m y is potentiallly extremely
y
complicaated, possiblyy involving a complex seeries of nested stochastic loops. For this
t
reason, a hierarchy off simplificatiions has beenn made availlable for com
mpanies to usse
where apppropriate.

Althoughh the risk maargin must bee disclosed seeparately forr each line off business, it is
proposedd that it can be
b reduced too take into acccount diverssification bettween lines of
o
business up to legal entity
e level. The allocatio
on of diversification beneefit can be
approxim
mated by apportioning thee total diverssified risk maargin across llines of
business in proportion n to the SCRR calculated on
o a standalo one basis forr each line, orr
by other approximatee methods if appropriate given
g the maateriality of th
the results.

1.5.6 Premiu
um provisiions and o
other aspe
ects

Best estim
mate premiu
um provision ns are equal to a best estiimate of futuure cashflows in
respect of
o unexpired exposures raather than thee unearned proportion off written prem miums.

Under Soolvency II:

 No credit is taken
n for deferredd acquisition
n costs
 No allowance
a is made
m for claaims equalisaation provisio
ons.

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1.5.7 Contract boundaries

When determining technical provisions, it is necessary to make an assumption

regarding the boundary of an insurance contract. Under Solvency II, the boundary
for existing insurance contracts is set at the point at which the company:

 Can unilaterally terminate the contract, refuse to accept a premium, or

 Amend the benefits or premiums in such a way that the premiums fully reflect the
risks.

This contract boundary sets the point at which premiums can be recognised on
existing contracts. Within the boundary period, both contractual recurring premiums
and premiums arising from policyholder options to renew or extend their policies
should be taken into account on a best estimate basis.

For example, if a non-life insurance undertaking is one year into a three contract at
the balance sheet date, allowance needs to be made for expected premiums and
claims, on a best estimate basis, during the remaining two years of the contract. This
could potentially have the effect of increasing or reducing technical provisions,
depending on whether or not the contract is expected to be profitable.

1.5.8 Legal obligations basis for unincepted contracts

The calculation of technical provisions also needs to include allowance for legally-
obliged unincepted contracts. These are contracts which have not yet incepted, but
the corresponding liabilities cannot be waived or reduced by the company as of the
valuation date.

The legal obligations basis may be material where business is written, for example,
by means of:

 Delegated underwriting authorities such as binders

 Brokers, for example in cases where there are backlogs of aggregated pipeline
premiums

 Year-end renewals, for example reinsurers entering into 1 January renewals prior to a
31 December valuation date

 Tacit renewal agreements where the business is automatically renewed unless the
policyholder decides to move the cover to another provider.

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1.5.9 Capital requirements under Solvency II

As explained above, in Pillar 1 the solvency system contains two capital requirements
defining the upper and lower end of a ladder of supervisory intervention. The Solvency
Capital Requirement (SCR) is the level above which there is no supervisory intervention
for financial reasons. The Minimum Capital Requirement (MCR) is the level below which
the supervisor’s strongest actions are taken (e.g. removal of the insurer’s authorisation).

1.5.10 Minimum Solvency Requirement (MCR)

The MCR is calculated for each individual line of business by taking the greater of:

 A factor applied to technical provisions (not including the risk margin) for each line of
business, net of reinsurance, subject to a minimum of zero

 A factor applied to written premiums in each line of business over the last 12 month
period, net of reinsurance, subject to a minimum of zero

The intention is that the MCR is calibrated to the Value-at-Risk of the basic own
funds of an insurance or reinsurance undertaking subject to a confidence level of
approximately 85% over a one-year time horizon.

The MCR factors, based on the Delegated Acts, are set out in the following table for
each line of business.

Line of business MCR factor MCR factor

– premium risk (%) – reserve risk (%)
Motor vehicle liability 9.4 8.5
Other motor 7.5 7.5
Marine, aviation and transport 14.0 10.3
Fire and other damage 7.5 9.4
General liability 13.1 10.3
Credit and suretyship 11.3 17.7
Legal expenses 6.6 11.3
Assistance 8.5 18.6
Miscellaneous financial loss 12.2 18.6
NPL property 15.9 18.6
NPL casualty 15.9 18.6
NPL marine, aviation and casualty 15.9 18.6

Notes: The above factors apply to direct, facultative reinsurance and proportional
reinsurance business, with the exception of the non-proportional reinsurance (NPL)
lines of business.

The resulting MCRs are summed across lines of business to obtain the overall MCR.

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The MCR must lie between 25% and 45% of the SCR.

1.5.11 Solvency Capital Requirement (SCR)

The Solvency Capital Requirement is calculated by combining a number of separate risk

charges, allowing for diversification credits by means of correlation matrices or other
methodologies.

The SCR is calibrated to the Value-at-Risk of the basic own funds of an insurance or
reinsurance undertaking subject to a confidence level of approximately 99.5% over a one-
year time horizon.

The SCR for each individual risk is then determined as the difference between the net
asset value (for practical purposes this can be taken as assets less best estimate liabilities)
in the unstressed balance sheet and the net asset value in the stressed balance sheet. These
individual risk capital amounts are then combined across the risks within the module,
using a specified correlation matrix and matrix multiplication.

Solvency II provides a range of methods to calculate the SCR which allows undertakings
to choose a method that is proportionate to the nature, scale and complexity of the risks of
the undertaking.

The SCR may be calculated using:

 A standard formula with simplifications

 A standard formula

 A standard formula with undertaking-specific parameters. If the standard formula is

used, non-life underwriting risk factors may, subject to prior supervisory approval, be
replaced with undertaking-specific parameters (“USPs”) which are calculated using an
undertaking’s own claims experience

 The combination of the standard formula for some risk factors and a partial internal
model for the remaining risk factors

 A full internal model. The use of an insurer’s (full or partial) internal model is subject
to prior supervisory approval.

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1.5.11.1 Structure of standard formula risk charges

The structure of the SCR risk charges in the standard formula is summarised in the
following diagram.

SCR

Adj BSCR Operational

Non-Life Market Health Default Life Intangible

Premium Currency SLT Non SLT Lapse Mortality

Reserve

Spread Mortality Premium

Reserve Expenses Longevity
Lapse

Interest rate Longevity Lapse Disability CAT

CAT
Property Expenses Revision
CAT
Equity Disability

Included in the adjustment for the loss absorbing capacity of

Concentration Revision TP under the modular approach

1.5.11.2 SCR – standard formula

The SCR, based on the standard formula, comprises the following risk charges:

 Operational risk

 An adjustment, which may include, for example, the loss absorbing capacity of
deferred taxes. This could comprise a reduction in any base balance sheet deferred tax
liability, as this would no longer be fully payable in a stressed scenario.

 Market risk (comprising interest rate risk, equity risk, property risk, spread risk,
currency risk and concentration risk)

 Non-life underwriting risk (comprising premium and reserve risk, catastrophe risk and
lapse risk)

 Life underwriting risk (comprising mortality risk, longevity risk, disability/morbidity

risk, expenses risk, revision risk, catastrophe risk and lapse risk)

 Health risk (comprising SLT health risk, non-SLT health risk and catastrophe risk)*

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 Counterparty default risk

 Intangible asset risk.

The various risk charges are combined together using the following formulae and
correlation coefficients:

SCR = BSCR + Adj + SCRop

[* Note: SLT stands for “similar to life techniques”]

The basic SCR (BSCR) is calculated using the following formula:

BSCR =  Corri, j ×SCR i ×SCR j +SCR Intangible

i, j

where the correlation coefficients Corri,j are taken from the following coefficient matrix:

Market Default Life Health Non Life

Market 1
Default 0.25 1
Life 0.25 0.25 1
Health 0.25 0.25 0.25 1
Non Life 0.25 0.5 0 0 1

1.5.11.3 Key values of factors in the SCR standard formula

The following key values of factors in the SCR standard formula are based on the
Delegated Acts. Some aspects of the calculation of the SCR using the standard formula
are complex, and so the following description is simplified significantly in some respects.

Operational risk

The operational risk charge is equal to the greater of 3% of gross earned premiums during
the previous 12 months and 3% of gross technical provisions, with the result being
subjected to a maximum of 30% of the basic SCR. It is assumed that there is no
diversification credit between operational risk and other components of risk.

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Non-life underwriting risk

The standard deviations used to calculate the premium and reserve risk factors in the
standard formula are set out in the following table. The standard formula calculates 99.5%
VaR factors from these standard deviations by multiplying the standard deviations by
three.

Line of business Standard deviation Standard deviation

– premium risk (%) – reserve risk (%)
Motor vehicle liability 10.0 9.0
Other motor 8.0 8.0
Marine, aviation and transport 15.0 11.0
Fire and other damage 8.0 10.0
General liability 14.0 11.0
Credit and suretyship 12.0 19.0
Legal expenses 7.0 12.0
Assistance 9.0 20.0
Miscellaneous 13.0 20.0
NPL property 17.0 20.0
NPL casualty 17.0 20.0
NPL marine, aviation and casualty 17.0 20.0

Notes: The above factors apply to direct and proportional reinsurance business, with
the exception of the lines of business labelled NPL which relate to non-proportional
reinsurance business.

The 99.5% VaR factors in respect of premium risk are applied to the maximum of:

 The estimate of net earned premium for each line of business during the forthcoming
year

 Net earned premiums for each line of business during the previous year.

The premium risk factors have been derived from claims development data which is gross
of reinsurance. For this reason, undertakings are permitted to multiply the premium risk
factors for each line of business by the following factors, which are intended to represent
the excess-of-loss reinsurance which is in place for each line of business

 80% for motor vehicle liability, fire and other damage, and general liability business

 100% for all other lines of business.

The 99.5% VaR factors in respect of reserve risk are applied to the best estimate for claims
outstanding for each line of business, after deducting the amount recoverable from
reinsurance and special purpose vehicles.

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There is scope, using a specified formula, for the premium risk and reserve risk factors to
be reduced by up to 25% to allow for geographical diversification.

Allowance is also made for:

 A correlation coefficient of 0.5 between premium risk and reserve risk factors
 Diversification by line of business.

Non-life catastrophe risk

The non-life catastrophe risk charge is determined using a complex series of formulae, and
comprises:

 A natural catastrophe risk sub-module, sub-divided between windstorm, earthquake,

flood, hail and subsidence risk

 A sub-module for catastrophe risk of non-proportional property reinsurance

 A man-made catastrophe risk sub-module, sub-divided between motor vehicle

liability, fire, marine, aviation, liability and credit & suretyship

 A sub-module for other non-life catastrophe risk.

Market risk

The equity risk charge is equal to 39% of the market value of equities for Type 1 equities
(equities listed in regulated markets in countries which are members of the EEA or the
OECD or shares of alternative investment funds authorised as European Long-term
Investment Fund) and 49% for Type 2 equities. A symmetrical adjustment (which will
vary from time to time within defined parameters) has been introduced to avoid pro-
cyclical effects – in other words, in general terms the equity stress will be smaller
following a decline in equity markets and will be higher following a period of strong
performance of equity markets. For example, in the EIOPA Technical Specification for
the Preparatory Phase dated 30 April 2014, this resulted in an adjustment of +7.5%,
increasing the Global equity and Other Equity stresses from 39% and 49% to 46.5% and
56.5% respectively.

The equity risk charge reduces to 22% of the market value for equity investments in
related undertakings where these investments are of a strategic nature.

The interest rate risk charge is determined by stressing the yield curve by specified
percentages, varying by the term to maturity. This will affect both the value of certain
classes of assets (for example fixed coupon bonds) and the value of liabilities (which are
discounted to allow for the time value of money).

The property risk charge is equal to 25% of the market value of properties.

The currency risk charge is calculated by assuming a 25% change in currency exchange
rates in respect of net currency exposures.

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The spread risk charge is determined through the use of a formula. For corporate bonds,
the loss on the assets is given by a function of the duration of the assets and the credit
rating of the underlying bonds, with lower requirements for public sector and mortgage-
covered bonds.

The concentration risk charge applies to holdings in excess of a specified threshold, and is
based on exposure, rating and total assets held.

Counterparty default risk

The calculation of the counterparty default risk charge differentiates between:

 Type 1 exposures which consist of a small number of counterparties which are usually
rated (for example reinsurers or derivative counterparties). The risk charges for type 1
exposures are based on a loss distribution derived from loss given defaults and default
probabilities

 Type 2 exposures where there is likely to be a diversified mix of counterparties which

are not rated. The risk charges for type 2 exposures are based on an immediate shock,
assuming losses of 90% of receivables which have been due for more than three
months and 15% on other receivables.

1.6 Internal model approval

If the SCR is calculated using a (full or partial) internal model, the company must obtain
prior supervisory approval.

The use of an internal model might be appropriate if the risk profile of the business differs
materially from that underlying the standard formula, and/or if the company already uses
such a model for risk management or other decision-making purposes (e.g. pricing,
investment strategy). The supervisor can require an insurance company to develop an
internal model if it considers that the standard formula is not appropriate to the risk profile
of the company.

Under some circumstances, the use of an internal model can potentially lead to less
onerous overall capital requirements than if the standard formula was used.

However, the internal model must still generate an SCR based on the stated requirements,
including coverage of the risk types as noted above and providing at least the equivalent
protection to a 99.5% confidence level over a one year time horizon.

To obtain supervisory approval, the internal model must pass the following tests, which
are discussed in more detail below:

 Use test
 Statistical quality standards

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 Calibration standards
 Profit and loss attribution
 Validation standards
 Documentation standards

1.6.1 Use test

Insurance and reinsurance undertakings need to demonstrate that their internal model is
widely used throughout all relevant areas of the business and that it plays a significant role
in the internal governance, risk management and decision-making processes, as well as the
economic and solvency capital assessments and capital allocation processes.

1.6.2 Statistical quality standards

The internal model needs to comply with a variety of specified criteria, including the
following:

 The methods used to calculate the probability distribution forecast are based on
adequate, applicable and relevant actuarial and statistical techniques

 The methods used to calculate the probability distribution forecast are based upon
current and credible information and realistic assumptions

 Data used for the internal model is accurate, complete and appropriate

 Insurance and reinsurance undertakings may take account in their internal model of
dependencies within and across risk categories, provided that the system used for
measuring these diversification effects is adequate.

1.6.3 Calibration standards

Insurance and reinsurance undertakings need to demonstrate that the output from the
internal model calculates the SCR in a manner which provides policyholders with a level
of protection equivalent to a Value-at-Risk of the basic own funds subject to a confidence
level of 99.5% over a one year time horizon

1.6.4 Profit and loss attribution

Insurance and reinsurance undertakings are required to review, at least annually, the
causes and sources of profits and losses for each major business unit. This includes a
requirement to demonstrate how the categorisation of risk chosen in the internal model
will be used to explain the causes and source of actual profits and losses.

1.6.5 Validation standards

Insurance and reinsurance undertakings are required to have a regular cycle of model
validation which includes monitoring the performance of the internal model, reviewing the
ongoing appropriateness of its specification, and testing its results against experience.

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1.6.6 Documentation standards

Insurance and reinsurance undertakings are required to document the design and
operational details of their internal model to demonstrate compliance with the above
requirements.

1.6.7 Practical considerations

The “use test” is seen as one of the most challenging aspects of gaining internal model
approval. As well as embedding the model throughout the company and developing an
effective risk culture, companies will need to be able to evidence that this is the case.

The quality of data and assumptions can also be an issue. A key challenge is that historic
data available to calibrate extreme events is limited. In practice, it is likely that some
industry consensus will emerge over some of the “core” stresses, e.g. 99.5th percentile
equity fall based on a benchmark index. It will be important for companies to adapt such
standards to allow for their own specific features, e.g. the extent to which their actual
equity holdings are more or less volatile than those underlying that benchmark. Similarly,
setting correlation factors that apply under extreme conditions is challenging.

An internal model can be structured in any way that the company chooses, provided the
above tests are met. It does not necessarily have to follow the structure of the standard
formula, and can for example be based on stochastic simulations rather than stress tests
plus correlation matrices. Calibration of such stochastic models will also require care and
expertise.

A tight deadline has been imposed of just six months from the supervisory authority
receiving an application for internal model approval to communication of the decision.
This is likely to prove challenging for the resources of regulatory bodies. Many
regulators (e.g. the PRA) have therefore chosen to set up a more informal approach (called
“pre-application”), encouraging companies to engage with them early on in their model
development and refinement processes.

Insurers will need to keep under regular review whether future major model changes are
needed for those who have their internal models approved by the PRA (will apply to
syndicates also). This will be similar to the main internal model approval process.

However minor model changes may be different. If changes are made and they are below a
threshold (say impact SCR less than 10%) then the model does not need to go for a major
model change and hence go through an approval process

1.7 Data quality

The Delegated Acts contain data quality requirements in the context of the calculation of
technical provisions.

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Data quality is deemed crucial because:

 The more complete and correct the data is, the more consistent and accurate final
estimates will be.

 The application of a wider range of methodologies for calculating the best estimate is
made possible, improving the chances of application of adequate and robust methods
for each case.

 Validation of methods is more reliable and leads to more credible conclusions, once a
reasonable level of quality of data is achieved.

 Effective comparisons over time and in relation to market data are possible, which
leads, for instance, to a better knowledge of the businesses in which the undertaking
operates and its performance.

It is also noted that the issue of data quality is relevant to other areas of the solvency
assessment, such as the SCR using either the standard formula or internal models. A
consistent approach to data quality issues needs to be taken across Pillar 1, without
disregarding the different objectives.

1.8 Corporate governance

Pillar 2 sets out requirements for the roles and responsibilities of key functions within the
business, with the Board having overall responsibility for ongoing compliance with
Solvency II.

The organisational structure must have clear segregation of responsibilities, the minimum
levels of which are defined within the Pillar 2 framework.

Companies need to have in place an effective system of governance which provides for
sound and prudent management of the business. They should have written policies in
respect of each of the following functions and ensure that these policies are implemented:

 Risk management
 Internal control
 Internal audit
 Actuarial

Companies also need to have written policies on outsourcing where such a process is
applied.

1.8.1 Risk management function

Article 44 of the Framework Solvency II Directive (Directive 2009/138/EC) states that

insurance and reinsurance undertakings shall have in place an effective risk-management
system comprising strategies, processes and reporting procedures necessary to identify,

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measure, monitor, manage and report, on a continuous basis the risks to which they are or
could be exposed and their interdependencies.

The risk-management system needs to cover at least the following areas:

 Underwriting and reserving

 Asset liability management
 Investments
 Liquidity and concentration risk
 Operational risk
 Reinsurance and other risk mitigation techniques.

1.8.2 Internal control

The scope of the internal control system includes:

 Administrative and accounting procedures

 An internal control framework
 Appropriate reporting arrangements at all levels of the undertaking
 A compliance function.

1.8.3 Internal audit

The internal audit function is responsible for evaluating the adequacy and effectiveness of
the internal control system and other elements of the system of governance.

The internal audit function must be objective and independent from the operational
functions.

1.8.4 Actuarial function

Article 48 of the Framework Solvency II Directive (Directive 2009/138/EC) states that

insurance and reinsurance undertakings shall provide for an effective actuarial function to:

 Coordinate the calculation of technical provisions.

 Ensure the appropriateness of the methodologies and underlying models used as well
as the assumptions made in the calculation of technical provisions.

 Assess the sufficiency and quality of the data used in the calculation of technical
provisions.

 Compare best estimates against experience.

 Inform the administrative, management or supervisory body of the reliability and

adequacy of the calculation of technical provisions.

 Oversee the calculation of technical provisions in the cases set out in Article 82.

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 Express an opinion on the overall underwriting policy.

 Express an opinion on the adequacy of reinsurance arrangements.

 Contribute to the effective implementation of the risk-management system referred to

in Article 44, in particular with respect to the risk modelling underlying the calculation
of the capital requirements set out in Chapter VI, Sections 4 and 5, and to the Own
Risk and Solvency Assessment (ORSA) assessment referred to in Article 45.

It is also stated that “the actuarial function shall be carried out by persons who have
knowledge of actuarial and financial mathematics, commensurate with the nature, scale
and complexity of the risks inherent in the business of the insurance or reinsurance
undertaking, and who are able to demonstrate their relevant experience with applicable
professional and other standards”.

The PRA have indicated that, while they consider that actuaries are well-placed to fulfil
the requirements of the actuarial function, they will not insist on the actuarial function
being undertaken by an actuary.

1.8.5 Own Risk and Solvency Assessment (ORSA)

In addition to calculating the MCR and SCR under Pillar 1, each insurance company will
be required to carry out an Own Risk and Solvency Assessment (ORSA). The ORSA is
defined by EIOPA as: “The entirety of the processes and procedures employed to identify,
assess, monitor, manage and report the short and long term risks an insurance undertaking
faces or may face and to determine the own funds necessary to ensure that the
undertaking’s overall solvency needs are met at all times.”

It requires each insurance company to identify all the risks to which it is subject and the
related risk management processes and controls. This will include some of the more
qualitative risks that have not necessarily been assessed under Pillar 1, such as reputational
risk.

The company must also quantify its ability to continue to meet the MCR and SCR over the
business planning horizon (usually three to five years), allowing for new business. This
does not have to be at a prescribed confidence level, but at a level that the company feels is
appropriate, for example relating to its own stated risk appetite and/or to achieving a target
credit rating.

Insurance companies will have to produce evidence to the supervisor showing that the
ORSA is used by senior management and that the impact on the ORSA is considered in
strategic decisions.

The ORSA should include at least the following components:

 The assessment of overall solvency needs (considering specific risk profile, approved
risk tolerance limits and business strategy).

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 Compliance, on a continuous basis, with capital requirements and requirements

regarding technical provisions.

 Consideration of the extent to which risk profile deviates from assumptions underlying
SCR calculated using the standard formula or partial/full internal model.

Companies should have an ORSA policy in place.

The ORSA should be an integral part of business strategy and considered in ongoing
strategic decisions.

The ORSA should be performed regularly (at least annually) and without delay following
any significant change in risk profile

There is a requirement to inform the supervisor of the results of each ORSA.

The ORSA process and outcome should be documented and independently assessed.

Companies should be able to explain and justify the following aspects of the ORSA:

 Methodology and assumptions

 Results and sensitivity of results to assumptions
 Appropriateness of methodology used
 Sources of data and systems and controls around the data
 Approach for dealing with parameter uncertainty and fluctuations

The documentation of the ORSA should at a minimum include:

 Description of areas included

 Description of process of conducting the ORSA and the responsibilities of key

personnel involved

 Stress tests used and their results

 The amount of overall solvency needs and financial condition of the undertaking,
including sign off by the administrative or management body

 Strategies for raising additional own funds where necessary

 A description of the independent assessment and results of the last assessment

 The frequency and contents of internal reporting.

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1.9 Reporting under Solvency II

The disclosure requirements are intended to increase transparency and so are more
extensive than the current Solvency I reporting regime. The aim of public disclosures is to
harness market discipline by requiring firms to publish certain details of their risks, capital
and risk management.

The results of the solvency calculation and details of the ORSA and risk management
processes will need to be disclosed in a Regular Supervisory Report (RSR) which can be
quarterly or annual.

Except for certain items which can be demonstrated to be of a confidential nature, these
will also be disclosed in a public Solvency and Financial Condition Report (SFCR),
produced annually.

Each of these documents should include at least sufficient information to assess:

 The system of governance applied by the undertakings

 The business they are pursuing
 The valuation principles applied for solvency purposes
 The risks faced
 The risk management systems
 Capital structure, needs and management

It is currently anticipated that the SFCR and RSR will contain at least the following
principal sections:

 Summary
 Business and Performance
 System of governance
 Risk profile
 Valuation for solvency purposes
 Capital management
 Additional voluntary information

EIOPA has also published detailed quantitative reporting templates (QRTs) for reporting
on an annual and quarterly basis of quantitative financial information under Solvency II.

1.10 Application of Solvency II to insurance groups

The intention is that Solvency II will enable insurance groups to be supervised more
efficiently through a “group supervisor” in the home country, co-operating with other
relevant national supervisors. This ensures that group-wide risks are not overlooked and
should enable groups to operate more effectively, whilst continuing to provide
policyholder protection.

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Each insurance group must cover its overall group SCR (which will allow for
diversification benefits across the group, and is subject to a minimum of the sum of the
MCRs of each subsidiary) and each insurance subsidiary needs to cover its own SCR.

Group supervision would normally be carried out at the top level company within the
European Economic Area (EEA). Additional rules apply to subsidiaries and parents
located in a “third country”, i.e. non-EEA. These broadly impose Solvency II
requirements or, in the case of a non-EEA parent, the establishment of an EU holding
company.

If the third country regulatory regime is considered to be broadly compliant with Solvency
II, then it is said to have third country equivalence and the group can be regulated as if
located in the EEA, replacing Solvency II rules with those of the third country regulatory
regime where appropriate.

Transitional arrangements are available to those non-EEA countries interested in pursuing

the third country equivalence route – Switzerland, Australia, Bermuda, Brazil, Canada,
Mexico and the USA have already been accepted on this basis.

1.11 Impact on business culture and strategy

It is important to obtain buy-in to Solvency II across the business, from Board level down.
This is the case for all insurance companies and not just those opting to use an internal
model – although as noted above, being able to demonstrate full integration of Solvency II
into the business is a key part of the internal model approval process.

Solvency II is not just a reporting framework, but a risk management framework with
implications for capital allocation, risk mitigation activities and performance management.

The Solvency II regime may also have an impact on the optimal product mix for the
company, and on product design.

It is also likely to impact the optimal asset mix for the company, since some asset classes
may become relatively more or less attractive as a result of their lower or higher capital
requirements.

The availability, or otherwise, of risk diversification benefits may also affect corporate
structures and generate merger and acquisition activity.

Management information is also likely to change to align the Solvency II metrics with the
business and strategic decision-making process.

External disclosures will change, and in general are likely to increase, so the impact on the
market also needs to be considered.

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1.12 Solvency II and approved roles

The following is the position as regards the Chief Actuary role and his/her approval as at
30 April 2016:

 All UK insurers must appoint a Chief Actuary, responsible for the actuarial function
role under Solvency II.

 This position can be filled by an internal employee or by a consultant.

 The IFoA has decreed that any member undertaking this task, must first obtain a
practising certificate (with appropriate qualification criteria).

 The PRA will follow the strict EIOPA guidelines such that person taking
responsibility needs relevant experience and competence but does not necessarily need
to be a fellow of a recognised actuarial association.

2 Lloyd’s — capital and solvency

2.1 Introduction
We have seen that managing agents carry out the technical insurance operations acting as
agents on behalf of members. For each year (separately) members undertake to accept
risks and take the profits or losses arising. A one-year group of members is called a
syndicate.

Lloyd’s maintains central assets for solvency, mutual capital that can at the discretion of
the Council of Lloyd’s, be used to pay members’ losses if the members are unable to (if
their FAL is exhausted). Central Assets for Solvency are mainly composed of the New
Central Fund and also include other central assets and subordinated debt.

Since members are taking risks, they need to hold capital. In this section, we explain how
this capital is held and how Lloyd’s centrally assesses how much capital each member
must have.

2.2 Funds at Lloyd’s

Each member must provide an amount of capital specified by Lloyd’s. The capital is held
by Lloyd’s in trust, and Lloyd’s has absolute authority to use it to pay claims or other
liabilities arising from the member’s activities at Lloyd’s. The capital fund of a member is
called Funds at Lloyd’s (FAL).

FAL may be lodged in two main ways: either through physical assets or through a Letter
of Credit (LoC). The assets must meet Lloyd’s admissibility criteria, which since 2007
have been equivalent to the asset admissibility criteria applied by the PRA to UK
insurance companies.

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LoCs are guarantees by banks to provide funds when called upon to do so by Lloyd’s.
Where FAL is provided by means of a LoC, Lloyd’s centrally has the unconstrained power
to call upon the guarantee (drawdown the LoC) whenever it wishes to, although in practice
it would only do so to meet liabilities or to maintain capital. LoCs for FAL must meet
certain criteria:

 Appropriate level of rating of the bank.

 Be available throughout a specified period, usually three years, known as “evergreen”.

If an LoC is not replaced annually, Lloyd’s would expect the member to lodge other assets
in FAL. If this did not happen, Lloyd’s would be able to call upon the LoC to obtain cash
to use as FAL.

Members are often able to obtain LoCs at low cost by collateralising them with other
assets. By using LoCs to provide FAL, members can exploit the “double use of assets”,
whereby they may be able to obtain normal investment returns on assets while using them
as collateral to obtain a good rate on an LoC and earn a second return at Lloyd’s. In
principle, the banks should charge a rate for the LoC that allows for any investment risk to
which the collateral assets are subject. However, the arrangement provides members with
great flexibility, and Lloyd’s centrally is fully protected by the terms of the LoC.

FAL are only needed for open years of account, and are held at member, not year of
account, level. That is, a member holds a single “pot” of FAL to cover the risks of all of
his/her open years.

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2.3 Solvency

Members are subject to two kinds of solvency tests. They must at all times meet the PRA
solvency test, and they must be “in line” from Lloyd’s perspective (satisfy a Lloyd’s
solvency test). These two tests are separate with the higher test prevailing.

2.4 PRA solvency

The PRA solvency requirements will be those of Solvency II from 1 January 2016.

2.5 In line
Lloyd’s has chosen to employ a derivative of the Solvency II SCR for member capital
calculations. This is the “ultimate SCR” (uSCR), which is a Solvency II SCR in which
insurance risk is taken to ultimate and not just one year as in the Solvency II SCR.
Syndicates must calculate both the normal SCR and the uSCR each year.

A member is in line if his or her FAL is at least equal to Lloyd’s capital requirement. The
requirement is discussed in Section 2.12 below, but is based on an individual capital
assessment (ultimate SCR) with an uplift to the “economic capital” level. The uplift is
currently a multiplicative 35%. Ordinarily there is a minimum capital requirement of 40%
of the member’s capacity. In this context, “capacity” is the maximum premium, gross of
reinsurance, but net of commission, that the member is permitted to underwrite in the
current years. Generally the capital required to be in line is much more than that required
to meet the PRA’s solvency test (also described in Section 2.12.4)

2.6 Solvency deficits

If the liabilities, including claims reserves and incurred but not reported (IBNR) claims, in
an open syndicate exceed the Premium Trust Funds (PTFs) of the syndicate, members
suffer “solvency deficits”. There may well be no immediate need for extra cash and hence
no cash call, but the solvency deficits are counted against the members’ FAL. This may
mean that a member ceases to be in line or, if the losses are large enough, ceases to meet
the PRA’s solvency test. Such a member would be required to deposit further assets into
the member’s FAL.

In the event that a member’s FAL is insufficient to meet the PRA test, central assets may
be used to demonstrate that member’s solvency.

2.7 Coming into line

A member whose FAL less solvency deficits are less than the Lloyd’s FAL requirement
is no longer in line. Lloyd’s has the power to require members to lodge further assets and
come back into line at any time, but has agreed to carry out this process twice a year in
normal conditions.

Each November, members who wish to underwrite in the following year must come into
line (CIL) in the main exercise, and each June all active members (members who are

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underwriting in the current year) must lodge assets if they have ceased to be in line. The
solvency position of members in the main CIL in November is that assessed as at the
preceding June, and in the June review it is at the preceding year end. However if it is
known that liabilities have increased since the last solvency calculation, Lloyd’s would
expect members to show that they had sufficient assets available to come into line as soon
as the liabilities were recognised.

In between CIL dates, Lloyd’s expects members to maintain FAL at least at the uSCR
level (see Section 2.12.2).

Lloyd’s ultimate sanction of members who are not in line is to limit, or totally stop, their
underwriting. Thus, when members cease underwriting of their own accord, Lloyd’s
cannot compel them to lodge further FAL.

2.8 Overall solvency

To calculate Lloyd’s overall solvency, the PRA’s solvency test is applied to the aggregate
of all members’ exposures. The assets available to meet the test are FAL and central
assets.

Lloyd’s must be able to demonstrate that central assets are sufficient to cover the total of
all members’ solvency deficits.

2.9 Continuous solvency

Lloyd’s is required to be solvent at all times, not just at year ends. The solvency position is
formally reassessed half-yearly, but a reassessment of the solvency position could be
applied at any time upon request by the PRA. This may be required following a major loss
scenario.

2.10 Statement of Actuarial Opinion (SAO) and Audit requirements

At the year end, each open syndicate year of account (YOA) requires an SAO and an
audit opinion. The SAO is required to separately cover each open year. Thus, at the end of
2015, a “normal” syndicate would require an SAO covering three years: the 2015 open
year, the 2014 open year and the 2013 open year which contains 1993–2012 by means of
past RITC.

There is a formal PRA requirement, contained in the PRA handbook, for each syndicate
open year to have an SAO. SAOs are produced under Lloyd’s valuation of liabilities rules,
which are in turn covered by actuarial guidance in the form of the TASs and the APSs.
The SAO reports will also be covered by the same guidance. The actuarial profession has
also issued advisory notes covering ULAE, bad debt and large loss wordings.

Actuaries signing SAOs must hold a practising certificate issued by the actuarial
profession.

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A final PRA requirement is that a designated actuary, the Lloyd’s actuary, must provide an
annual certificate to the PRA certifying that every non-life syndicate has obtained an SAO
in line with formal requirements and comment on uncertainty at an aggregate Lloyd’s
level specifically in terms of materiality. If there is no SAO for any open year, the Lloyd’s
actuary must provide an equivalent opinion.

SAOs include results on both a gross and net of reinsurance basis. The net opinions must
also allow for unallocated loss adjustment expenses (ULAE) and bad (or doubtful) debt on
expected reinsurance recoveries. The opinion the actuary is giving is a “one way” test and
certifies that the technical provisions being opined on are at least as large as the actuary’s
best estimate. In this context, best estimate is defined as the mean (as opposed to median)
expected outcome. Opinions can also contain additional comments on uncertainty, where
the signing actuary will comment on large events or circumstances that increase the
uncertainty of estimates.

Each SAO must be supported by a formal actuarial report addressed to the managing
agents with a copy submitted to Lloyd’s.

Syndicates writing life business require an actuary’s certificate rather than an SAO. These
are outside the scope of this Core Reading.

Syndicates writing business in the USA will be additionally required to hold assets in
specific USA trust funds. The liabilities for each of the credit for reinsurance trust fund
(CRTF) and surplus lines trust fund (SLTF) are also subject to actuarial opinion as
required by the USA regulators. Preparation of the USA trust fund opinions is covered by
actuarial guidance contained in APS G2.

Syndicates also require an audit opinion on the financial statements of the syndicate. The
auditor providing these opinions will place heavy reliance on the SAO.

The opinions form part of the annual reporting process syndicates undertake. The
reporting contains accounting, financial and other information items which are aggregated
into Lloyd’s statements and returns.

2.11 Capital setting – introduction

In the section on solvency, we have seen that:

 members, not syndicates, have to be solvent under the PRA rules and have to be in
line if they wish to continue underwriting

 if members fail the PRA solvency test, then Lloyd’s centrally must demonstrate that it
can cover their shortfalls

 member capital is made up of FAL, supplemented or offset by surplus or deficiencies

in the syndicates to which they subscribe

 central capital is made up of the New Central Fund (NCF) plus other central assets
(called altogether central assets for solvency)

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In this section, we explain how the requirement for member FAL is assessed, and briefly
also how Lloyd’s assesses its overall capital needs.

2.12 Member FAL

2.12.1 History: Risk-based capital (RBC)

From 1996 until 2006, member FAL was based on the Lloyd’s RBC system. This was an
actuarial model, parameterised and maintained centrally, that derived capital requirements
for members based upon their membership of syndicates in the past, current and proposed
years off account, together with information on what volumes and classes of business the
syndicates had written and proposed to write.

Thus for the 2005 year of account, RBC was calculated in November 2004
and covered actual volumes for 1993–2003, estimated volumes for 2004 and proposed
(plan) volumes for 2005. An inherent feature of RBC was that it treated all syndicates as
being alike. £1 of premium written in a particular class of business in a particular year was
presumed to generate the same exposure whichever syndicate had written it. This “market
average” approach made RBC relatively simple and robust. But many felt that, as well as
class of business and year of account, the underwriting syndicate also influenced the
riskiness of member’s portfolio.

RBC allowed for diversification between classes of business, between managing agents
and over time. It had (syndicate specific, not market average) components reflecting
property catastrophe risks which were called realistic disaster scenarios (RDS).
In an actuarial capital assessment, two main ingredients are a probability distribution of
outcomes and a risk measure that determines a capital amount given that probability
distribution. In RBC, the probability distributions at member level were assumed to be
drawn from the gamma distribution, with property catastrophe distributions (RDS) added.
The risk measure was expected loss cost (ELC). The expected loss in excess of FAL was
set at a particular figure and RBC calculated FAL per unit of exposure such that ELC was
the same for each member, per unit of exposure. Total FAL was obtained by multiplying
FAL per unit of exposure by the exposure.

For example, we may assess a particular member as having £10 million of exposure, based
upon past current and proposed volumes and on market average loss ratios and payment
patterns. We assess the volatility of the member’s exposure allowing for line of business
volatilities and correlations, all at market average, and derive an appropriate gamma
distribution. The mean of the gamma would be 100% because we assume that reserves are
held at best estimate. We would adjust the gamma for RDS if the member had catastrophe
exposures. Based on the adjusted gamma distribution for that member, FAL of, say, 0.12
per unit of exposure would give the ELC for that year. That is, the expected value of losses
if 12p of capital were held would be equal to the fixed ELC. The member’s required FAL
would then be £1.2 million.

2.12.2 History: ICAs

To set the Solvency II context, Lloyd’s was, since 2006, subject to the ICAS regime
(originally under the FSA and now under the PRA) and each syndicate was required to

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produce an ICA. The ICA risk measure was 99.5% value at risk; that is, the ICA capital, at
syndicate level, was that required so that the probability of losses beyond that level was
0.5%. Syndicates were required to carry out ICAs by the PRA’s rules, but it was Lloyd’s
decision to use the ICA as a tool to set member capital. In principle, provided syndicates
carried out an ICA and provided members held at least ICA levels, or else Lloyd’s held
capital to cover shortfalls, the society met the requirements, although it was unlikely that
the PRA would accept an approach not closely based on the ICAS (or now Solvency II)
system..

In view of this, Lloyd’s decided to take syndicate ICAs as the starting point in calculating
member FAL requirements. The first step was to review each ICA to ensure that it met
Lloyd’s standards (see below).

Once an ICA had been approved, the next step was to apply the “economic capital uplift”
and derive the “ECA” (ECA means “economic capital level ICA”). The idea of economic
capital was that the ICA standard of security was the minimum acceptable to the regulator,
but Lloyd’s security was well above the minimum. The level of ECA relative to ICA was
set so that (a) overall member capital remained about the same during the transition from
RBC to ICAs and (b) member capital requirements at Lloyd’s remained lower than it was
judged a standalone company with the same rating would be, but sufficient so that together
with central capital the overall Lloyd’s rating could be maintained.

The mechanism for setting syndicate ECA based on syndicate ICA was a simple one: ECA
was 135% of ICA. The uplift was therefore 35% of the ICA. It was therefore somewhat
risk-based because a riskier syndicate, with a higher ICA, got a higher uplift. But it was
transparent and not mathematically complex.

Both the method of uplifting (multiplicative) and the level (135%) were subject to annual
review and signoff by the franchise board.

On 1 January 2016, the ICA regime was superseded by the Solvency II regime. The
member capital system changed to the Solvency II equivalent, in which the uSCR
replaced the ICA as the base for member capital setting.

2.12.3 Member capital requirement

The ICA system and the economic capital uplift produced risk-based capital levels that
met Lloyd’s requirements, but it was still necessary to convert syndicate ECAs into actual
member FAL requirement and to demonstrate that FAL together with central assets
produce the right level of overall security. Lloyd’s carried out this process centrally. As
noted in 2.12.2 above, the system now applying under Solvency II uses the uSCR to
replace the ICA in the member calculation.

2.12.4 Minimum FAL

Once each member’s capital requirement has been calculated, a minimum is applied. The
minimum is set at 40% of the member’s overall premium income limit (OPIL), also called
member capacity. Premium is defined as gross of reinsurance, net of brokerage, and OPIL
is calculated by summing the respective syndicate capacity times members share.

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Syndicate capacity is approved as part of the business plan approval process, and is the
maximum premium that the syndicate is permitted to underwrite in the year.

The 40% minimum is reduced to 25% for some personal-lines business, where it would
pose uncompetitive capital burdens and produce higher capital than was required on a risk
based assessment. A member obtains the waiver only if at least 85% of risks fall into the
personal-lines category.

2.12.5 uSCR review

Before syndicate uSCRs can be used, they must have been received and approved by
Lloyd’s. The PRA retains the final ownership of the uSCR process and carry out some
reviews of their own, but for most syndicates, the Lloyd’s review is accepted by the PRA.
This mandate needs to be renewed each year.

Lloyd’s review starts with the issuing each year of Lloyd’s uSCR guidance, which sets out
the requirements and minimum standards Lloyd’s expects. The guidance also offers
detailed advice on how to carry out various aspects of the uSCR.

Managing agents produce draft uSCRs in July each year and final versions in September
or October. Lloyd’s review teams go through each uSCR in detail and provide feedback.
Where the uSCR number appears too low, Lloyd’s will ask the managing agent to review
it, and ultimately will load the uSCR if necessary.

The reviews are carried out by teams drawn from finance, actuarial, FPD (franchise and
performance directorate), risk management and other departments. The review team’s
feedback and, if necessary, loading is approved by a steering committee. If the managing
agent is dissatisfied, it may appeal to a director and then to an external committee, the
market supervision and review committee (MSARC).

In parallel with the uSCR review, syndicates’ plans for the proposed year are reviewed. By
the end of October, each syndicate needs to have reached the stage that both its plans and
its uSCR, based on the same plan, have been approved by Lloyd’s. Members indicate the
syndicates to which they wish to subscribe, and may buy and sell these rights to subscribe
in auctions held in November. Coming into line takes place in November. Each member’s
FAL requirement is calculated and assets must be lodged with Lloyd’s by this date. For a
syndicate to be allowed to underwrite from 1 January of the following year, all of its
members must be in line.

2.12.6 Central capital

Once all members are in line, Lloyd’s can assess its overall capital position. The security,
and hence solvency and rating, depend on both FAL and central assets. FAL are set
bottom-up as uSCR times 135% less a credit for member diversification. However, even
with the 35% uplift, the probability of some member failing is higher than the required
0.5%: P (a member fails) = 1 – P (no member fails), and members are diverse so P (no
member fails) < P (a particular member does not fail).

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In practice, calculating the probability that some member exhausts the FAL and “fails”,
hence calculating how much central capital is needed, is very complex. A detailed
simulation model is used to simulate member experience. Correlation between members is
included in the model. From the simulation output, an overall distribution of losses beyond
FAL is derived and from this a Lloyd’s Society SCR is calculated as central assets such
that the probability of their being inadequate is 0.5%. The Lloyd’s SCR is calculated on
the normal one-year SCR basis, and is calculated in two ways: the Market Wide SCR
(MWSCR) represents all of the capital consumed at 1 in 200, from whatever source, and
the Central SCR (CSCR) the central capital needed at 1 in 200. [Thus the MWSCR
includes the CSCR, although the nature of VaR calculations is such that the 1 in 200 event
for the whole market is different from the 1 in 200 for central assets.] The MWSCR can
be compared directly with the SCRs of other insurers.

An “economic capital” central capital (only) assessment is made for the ORSA. This is a
materially higher level of capital than the CSCR, and the details are beyond the scope of
this reading.

2.12.7 Assets

The new central fund (NCF) is composed of cash and investments plus the proceeds of
two subordinated debts.

2.13 Overview of Lloyd’s prudential requirements

The Society of Lloyd’s:

To maintain appropriate controls over the funds that it holds and manages centrally
including managing risk within appropriate limits.

To assess the capital needs for each member, taking into account the capital needs of
syndicates assessed by managing agents.

Managing agents:

To maintain appropriate controls over syndicates including managing risks such as credit
risk and market risk within limits that are substantially the same as those defined for
companies.

To assess the capital needed to support each syndicate that they manage, to help to ensure
that financial resources are adequate at all times.

Lloyd’s of London – Solvency II

http://www.lloyds.com/The-Market/Operating-at-Lloyds/Solvency-II

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2.13.1 Lloyd’s and the PRA

This section sets out the Prudential Regulation Authority’s (PRA’s) expectations in
relation to the application of certain parts of Solvency II to Lloyd’s, and expands
upon the Lloyd’s Part of the PRA Rulebook.

In particular, this statement sets out the PRA’s expectations regarding the
following topics:

 solvency capital requirement (SCR) and

 capital add-ons

This statement expands on the PRA’s general approach as set out in its insurance approach
(1)
document. By clearly and consistently explaining its expectations of Lloyd’s in relation
to the particular areas addressed, the PRA seeks to advance its statutory objectives of
ensuring the safety and soundness of the firms it regulates, and contributing to securing an
appropriate degree of protection for policyholders. The PRA has considered matters to
which it is required to have regard, and it considers that this statement is compatible with
the Regulatory Principles and relevant provisions of the Legislative and Regulatory
Reform Act 2006. This statement is not expected to have any direct or indirect
discriminatory impact under existing UK law.
(2)
This statement has been subject to public consultation and reflects the feedback that
was received by the PRA.
(1)
The Prudential Regulation Authority’s approach to insurance supervision, June 2014;
http://www.bankofengland.co.uk/publications/Documents/praapproach/insuranceappr
1406.pdf.
(2)
PRA Consultation Paper CP16/14, “Transposition of Solvency II: Part 3”, August 2014;
htttp://www.bankofengland.co.uk/pra/Documents/publications/cp/2014/cp1614.pdf.

2.13.2 Solvency capital requirement

The requirement to hold eligible own funds covering the central requirement is intended
to ensure that risks to the Society, including risks to central assets (and in particular, the
risk that own funds attributable to a member may not be sufficient to enable the member
to meet obligations arising from the member’s insurance business at Lloyd’s) are suitably
covered by the Society.

Solvency Capital Requirement — General Provisions 6.6 recognises in its application to

Lloyd’s that own funds attributable to a member are not available to absorb the losses of
other members, or any losses of the Society. Consequently, in respect of own funds
attributable to a member, where there is no diminution in those own funds consequent
upon the application of scenarios taken into account in the internal model, those own
funds attributable to that member must not be taken into account for the purposes of
satisfying Solvency Capital Requirement — General Provisions 6.2. Similarly, in

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respect of own funds attributable to a member, any surplus of own funds in excess of the
diminution to those own funds consequent upon the application of the scenarios taken
account of in the internal model, must not be taken into account for the purposes of
satisfying Solvency Capital Requirement — General Provisions 6.2.

The notional syndicate SCR is intended to facilitate the Society’s compliance with
Solvency Capital Requirement — General Provisions 8.2. While the PRA expects the
calculation of the notional SCR to meet the relevant standards required under Solvency II,
managing agents do not need to seek separate approval from the PRA for any internal
model that is used to calculate the notional SCR of a syndicate. The notional SCR will
also assist the Society in determining the notional SCR of each member of the syndicate
pursuant to Solvency Capital Requirement — General Provisions 8.4. However, the
notional member SCR will, to the extent applicable, also take account of diversification
effects in respect of members participating on more than one syndicate which have not
been reflected in the notional syndicate SCR.

In deriving the SCR, the Society should have regard to the notional SCR for each
syndicate, that is calculated by managing agents either by reference to the standard
formula or an internal model. However, the Society should make its own assessment of the
risk profile and governance arrangements in respect of each syndicate, in conjunction with
the methodology applied by each managing agent to calculate the notional SCR. It may
need to increase a notional syndicate SCR, and hence the overall SCR for Lloyd’s, if it
concludes that there are additional risks to which the Society is exposed in relation to the
business written by a syndicate, that would not otherwise be covered, when performing the
calculations envisaged by Solvency Capital Requirement — General Provisions 7.

The approach set out in Solvency Capital Requirement — Internal Models 17.2 is, when
combined with the internal model requirements set out in Solvency Capital Requirement
— Internal Models 10 to 16 and Solvency Capital Requirement
— General Provisions 8.2, intended to produce, for each risk taken into account in the
internal model, the negative impact on basic own funds at Lloyd’s. In this way, the effect
of the application of the risks taken into account in the internal model may be determined
in respect of Lloyd’s as a whole.

2.13.3 Capital add-on

Solvency Capital Requirement — General Provisions 7.3 requires the Society to calculate
a central requirement for Lloyd’s. As the central requirement forms part of the Lloyd’s
SCR, the provisions of Article 37 of the Solvency II Directive will apply in respect of any
risk profile deviation on the part of the Society from the assumptions underlying the
calculation of the central requirement. The PRA will use its powers under section 55M of
the Financial Services and Markets Act 2000 (FSMA) in order to apply any capital add-on
to the Society. The Solvency II Regulations also apply in relation to the imposition of a
capital add-on.

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3 Further reading

Readers may find the following links to be useful sources of further information:

Solvency II Directive
http://register.consilium.europa.eu/pdf/en/09/st03/st03643-re01.en09.pdf

Actuarial Association of Europe – Solvency II

http://actuary.eu/current-topics-solvency-ii/solvency-ii/

Prudential Regulation Authority – Solvency II

http://www.bankofengland.co.uk/pra/Pages/solvency2/updates.aspx

Insurance Europe – Solvency II

http://www.insuranceeurope.eu/solvency-ii

Lloyd’s of London – Solvency II

http://www.lloyds.com/The-Market/Operating-at-Lloyds/Solvency-II

END

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