Understanding the Supervision Component of Solvency II

Episode Summary

Host Robert Chaplin and guest James Pickstock cover the Solvency II supervision framework, which is designed to protect policyholders and promote insurer soundness. They focus on the Regular Supervisory Report (RSR), a quantitative tool that is among four key areas that insurers must disclose to supervisors. Robert and James also look ahead to legislative reform effective at year’s end.

Watch for our next episode, which will focus on the Solvency and Financial Condition Report, another key area that must be reported to supervisors.

Key Points

• Supervision Framework: Under Solvency II, regulators in an insurer’s home jurisdiction review the insurer's operations and continued regulatory compliance.
• Principle of Proportionality: While Solvency II aims to ensure that supervision is effective but not burdensome, insurers – especially small ones that don’t pose significant risks – have suggested that the regime hasn’t reduced the regulatory burden.
• Can the Firm Cause Harm? The Prudential Regulation Authority (PRA) categorizes firms according to their potential to harm the stability of the U.K. financial system.
• Capital Add-Ons: If a regulator decides that action needs to be taken, these are among the more powerful tools in a supervisor's regulatory arsenal, and imposing them is not taken lightly. Rob outlines the four situations where capital add-ons could be imposed.

Voiceover (00:01):
From Skadden, the Standard Formula is a Solvency II podcast for UK and European insurance professionals. Join us as Skadden partner, Robert Chaplin, leads conversations with industry practitioners and explores Solvency II developments that matter to you.

Rob Chaplin (00:18):
Welcome back to the Standard Formula Podcast. I’m your host, Rob Chaplin. Today we’re exploring the supervision framework under Solvency II. The primary objective of the supervision framework is to protect policyholders in addition to promoting the safety and soundness of insurers. I’m delighted to be joined by my colleague James Pickstock. James, please give us a brief overview of the supervision framework.

James Pickstock (00:45):
Thanks, Rob. The prudential supervision of an insurer is the sole responsibility of the regulator in that insurer’s home jurisdiction. The Solvency II regime adopts a prospective, risk-based approach involving reviews of an insurer’s operations and its continued regulatory compliance. Supervisors review and evaluate the strategies, processes, and reporting procedures which are established by an insurer to comply with the relevant laws, regulations, and administrative provisions. This review must include assessments of the qualitative requirements relating to the system of governance, the risks which the insurer faces or may face, and the ability of the insurer to assess those risks given the environment in which it operates.

(01:27):
In particular, the review should focus on the system of governance, including the own risk and solvency assessment, technical provisions, capital requirements, investment rules, and the quality and quantity of own funds. Supervisors also have monitoring tools in place to allow for timely identification of deteriorating financial conditions, powers to compel action where such circumstances arise, and further monitoring tools to assess how the deterioration is remedied.

Rob Chaplin (01:57):
Thanks, James. Does the regime differentiate between different types of insurers?

James Pickstock (02:02):
That’s a great question. Throughout the regime, there’s the principle of proportionality, which is designed to ensure that it’s requirements are applied in a manner that’s proportionate to the nature, scale and complexity of risks inherent in the business. The goal is to ensure that supervision remains effective without being overly burdensome. However, there has been consistent feedback from insurers suggesting that the implementation of the proportionality principle has been unsuccessful in reducing regulatory burden, especially for small insurers that don’t pose significant risks. Legislative efforts in Europe have finally led to changes. Some of which update the principle of proportionality and simplify the supervision regime.

(02:44):
There are two key changes here. First, the size threshold for insurers excluded from Solvency II regulatory scope is increasing. Second, the changes also introduce a new classification of small and non-complex undertakings. These undertakings automatically qualify for proportionality measures such as less frequent reporting requirements, whereas other undertakings will have to obtain prior approval from their supervisors to use the measures. The UK has followed suit by improving its proportionality regime. Recent reforms increase the size of thresholds above which the firm enters the regime and simplify the overall reporting framework.

(03:23):
Insurers will only be exempt from the framework if they haven’t exceeded the UK thresholds for three consecutive years and don’t expect to do so in the following five. Small insurers who aren’t regulated by the framework are instead subject to a simple regime. The UK reforms take effect from the 31st December 2024. Under both the UK and EU frameworks, insurers that don’t exceed the new increased thresholds will continue to be able to operate under the Solvency II regime should they wish to by applying for a voluntary requirement. Let’s now delve into the specifics of what information insurance undertakings are required to provide to supervisors to enable them to fulfill their supervisory duties. Over to you Rob.

Rob Chaplin (04:05):
Insurers must submit to supervisors all information that’s necessary for the purposes of supervision. The recent amendments to the directive include wording to underscore the importance of applying proportionality in deciding what’s necessary. The information submitted must reflect the nature, scale and complexity of the undertaking and the risks inherent to it. At a minimum, the information supplied must allow supervisors to assess the undertaking system of governance, business, evaluation principles, capital structure, the risks it faces and risk management systems in place, allowing the authorities to make appropriate decisions.

(04:47):
This information must comprise qualitative or quantitative elements, historic, current or prospective elements and data from internal or external sources. Supervisors are empowered to determine the precise nature, scope, and format of information they require undertakings to provide as part of the supervisory process. Insurers must have a written policy supported by appropriate systems and structures to allow them to fulfill their reporting requirements.

James Pickstock (05:16):
Rob, we briefly touched on the information to be provided. Could you walk us through the process and how this information is supplied to the relevant authorities?

Rob Chaplin (05:24):
With pleasure. Insurers must regularly disclose information to supervisors. This can be segregated into four key components. The Solvency and Financial Condition Report or SFCR. The regular Supervisory Report or RSR. The Own Risk and Solvency Assessment or ORSA and annual and quarterly quantitative reporting templates. Today we’ll focus on the RSR and quantitative reporting. We covered the ORSA in a previous episode. We’ll cover the SFCR in our next podcast. James.

James Pickstock (06:02):
Thanks, Rob. The RSR must include information relating to the undertaking’s business and performance, system of governance, risk profile, valuation for solvency purposes, capital management over the reporting period, a summary highlighting any material changes that have occurred in these respects and a concise explanation of the causes and effects of such changes. At the general level, the RSR follows the same structure as and contains information additional to that’s included in the relevant firm’s SFCR. The RSR is submitted at least every three years. Although supervisors may require an insurer to submit its RSR at the end of any financial year.

(06:41):
Even when there’s no requirement to submit an RSR for a given financial year, insurers must still submit a report setting out any material changes that have occurred in the undertaking’s business and performance system of governance, risk profile, valuation for solvency purposes and capital management over the given financial year and provide that concise explanation of the causes and effects of such changes. The deadline to submit the RSR is currently set at no later than 14 weeks after the insurer’s financial year-end. Supervisors are able to limit regular supervisory reporting or exempt insurers reporting on an item-by-item basis.

(07:19):
Specifically, where submission of the information would be overly burdensome in relation to the nature, scale and complexity of the risks inherent in the undertaking, where the information isn’t necessary for effective supervision, where the exemption doesn’t undermine the stability of the financial systems of the jurisdiction and where the undertaking can provide the information on an ad hoc basis. However, the exemption can only be granted to undertakings that don’t represent more than 20% of that jurisdiction’s life and non-life markets. To make the regime more proportional, the EU changes adapt the reporting requirements to be better suited to the size, nature, and complexity of the relevant firm.

(07:59):
They adapt the reporting requirements for small and non-complex undertakings, giving access to exemptions and limitations for regular supervisory reporting, and opening the possibility for supervisors to permit them to submit their RSR every five years instead of every three. The changes also extend the submission deadline for the RSR from 14 weeks to no later than 18 weeks after the end of the financial year. Similarly, the UK’s already implemented some simplifications to reduce reporting burdens under its regime. With some additional reforms taking effect on the 31st of December 2024. The focus of the UK reforms has been on reducing the volume of information that Solvency II firms are required to report.

(08:42):
Making it less burdensome for firms while ensuring that the PRA still receives the necessary information to conduct effective supervision. One of the key reforms which took effect in December 2023 was the PRA’s decision to remove the requirement to submit the RSR for all Solvency II firms including UK branches of international insurers. PRA recognized that the report was burdensome to prepare and that triennial reporting frequency of the RSR would not provide timely information. The rest of the framework in the PRA’s opinion allows for the collection of information that’s needed for supervision.

Rob Chaplin (09:20):
Thanks, James. Moving on from the RSR, there’s a set of quantitative reporting templates provided for under the Solvency II directive. This is a separate set of reporting requirements which are to be submitted both quarterly and then also annually. It’s recognized that the reporting requirements can be onerous, hence the production of templates for reporting. The driving principle behind the system was to ensure that an adequate level of detailed information would be provided and that the level of reporting would be consistent across jurisdictions.

(09:55):
The templates were intended to provide an easy, accessible and accurate overview of system of governance, business pursued, valuation principles applied for solvency purposes, risks faced, risk management systems and capital structure, capital needs and capital management. We’ve been consistently coming back to proportionality. James, are the changes underway for quantitative reporting as well?

James Pickstock (10:23):
Absolutely. We mentioned earlier that there is disquiet in the industry with the directive’s reporting obligations. While the original goal was to ensure convergence in reporting standards, a one-size-fits-all approach didn’t work. In the UK, the PRAs amended its approach to categorize undertakings according to their potential to adversely affect the stability of the UK financial system by failing, coming under operational or financial stress or because of the inherent way in which they carry out business.

Rob Chaplin (10:51):
James, let’s run through those categories before we get into the detail of what a firm’s category means for its quantitative reporting obligations, please.

James Pickstock (11:00):
Of course, it’s helpful to think of the four categories as somewhat of a sliding scale. Undertakings are designated from category one being the most significant insurers whose size, interconnectedness, complexity and business type give them the capacity to cause very significant disruption to the UK financial system should they fail or by carrying on business in an unsafe manner. This then cascades down into category two, being businesses with the capacity to cause some disruption. Category three, causing minor disruption and category four causing almost no disruption.

(11:32):
The PRA considers a range of factors in determining any given firm’s category, including lines of business and risks insured and whether these have the potential for significant adverse effects on policyholders if cover were not maintained or obligations not paid. Now you may well think why is this important? In line with our discussion so far, it’s evident that proportionality as an objective as initially introduced has not resulted in the practical application envisaged by its creators. We know that each jurisdiction has its own templates for its reporting. However, the UK regime is envisaging more simplifications and in some cases complete exemptions from quarterly reporting.

(12:12):
Those firms which are categorized by the PRA as categories three or four, whether individual or part of a group, are eligible to apply to limit their quarterly reporting, but it’s not as easy as it may seem. While firms may be granted an exemption to their reporting status, there are a couple of important caveats to note. First, undertakings benefiting from the exemption will still be required to submit basic information such as an overview of their submission, their balance sheet, and information on their own funds. Second, the PRA may make ad hoc requests for quarterly reports from any firms holding such a waiver.

(12:50):
Interestingly, there are times in the PRA will consider exemption applications from category one and two firms despite their more critical roles. Albeit very strictly on an exceptional basis.

Rob Chaplin (13:01):
Thanks, James. Now let’s shift our focus to the powers of the supervisors. James, could you elaborate on the range of powers that supervisors have under the Solvency II framework and how these powers are utilized to ensure compliance?

James Pickstock (13:16):
Of course. Thanks, Rob. Supervisors have a wide suite of preventative and corrective regulatory powers, including the ability to take any necessary measures including administrative and financial measures where appropriate. They also have the ability to carry out on-site investigations at the insurer’s premises and to require all information necessary to conduct supervision.

(13:38):
Their general supervisory powers also include the ability to develop quantitative tools and require corresponding testing in addition to the solvency capital requirement to assess the ability of insurers to withstand future events or changes in economic conditions. Rob, why don’t you take us through what happens if the regulator decides that reporting shows that action needs to be taken?

Rob Chaplin (14:00):
One of the more powerful tools in a supervisor’s arsenal is requiring a capital add-on in addition to the solvency capital requirement. Now, we should stress that the Solvency II directive emphasizes that the imposition of a capital add-on is not a step which is taken lightly. There are four key situations in which this could arise. One, the risk profile of the firm deviates significantly from the assumptions underlying the SCR as calculated using the standard formula and either a requirement to use an internal model is inappropriate or ineffective or during the period while a full or partial internal model is being developed.

(14:45):
Two, the risk profile of the undertaking deviates significantly from the assumptions underlying the SCR as calculated using an internal or partial internal model that certain quantifiable risks are captured insufficiently and the adaption of the model to better reflect the given risk profile has failed within an appropriate timeframe. Three, the system of governance of the undertaking deviates significantly from the standards dictated by the directive and those deviations prevent it from being able to properly identify, measure, monitor, manage, and report the risks that it is or could be exposed to and that the application of other measures is in itself unlikely to improve the deficiencies sufficiently within an appropriate timeframe.

(15:33):
Or four, the undertaking applies the matching adjustment, the volatility adjustment, or transitional measures, and the supervisory authority concludes that its risk profile deviates significantly from the assumptions underlying them. Now, James, that was a lot to digest. What are the key takeaways?

James Pickstock (15:52):
So there are two key items. First, it’s the supervisor’s ultimate view and the extent to which there is a deviation from the SCR. In respect to the supervisor’s view, this will be a holistic view taking into account all information. The deviation aspect depends on the degree to which a firm has deviated from the underlying assumptions in the undertaking’s SCR. In the UK, the PRA will additionally consider any relevant factors, such factors including the nature, type and size of any deviation, the likelihood and severity of any adverse impact on policyholders, the level of sensitivity of the assumptions to which the deviation relates and the anticipated duration and volatility of the deviation over its duration.

Rob Chaplin (16:35):
And helpfully, the PRA provides numerical in addition to situational guidance where the PRA detects a risk profile deviation of under 10%, the PRA may determine there is a sufficient risk of deviation from SCR assumptions where more than 10% and less than 15%. The PRA expects to conclude that there will be a significant deviation unless there is strong evidence to the contrary. And where there is more than 15%, the PRA expects to conclude that the risk profile deviates from the SCR assumptions. James.

James Pickstock (17:12):
Thanks, Rob. Now we may come back to the minutiae of capital add-ons in a future podcast, but for now there are two final thoughts to take away. First, the general approach to calculating the capital add-on. The PRA may decide to express the capital add-on as a fixed amount or with reference to certain outputs calculated by the undertaking to enable the capital add-on to respond dynamically over time. Second, once there is a capital add-on, how is it removed? The PRA will request updates on progress towards remedying the deficiencies that led to the capital add-on and the measures taken by an undertaking.

(17:48):
It is the supervisor’s goal to have the undertaking restored to usual operations as soon as practicable and its role to monitor and support the undertaking to do so, and it is looking for evidence via reporting and also information volunteered by the undertaking itself, which lead to material changes allowing for the removal of the capital add-on and resumption of business as usual.

Rob Chaplin (18:11):
Thanks, James. That’s an excellent note to end on and brings us to the end of this episode. Thank you for joining us. In case you missed it, our last episode covered undertakings and difficulty, and our next topic will be the SFCR and other public reporting. If you have any questions or comments on any of the topics we spoke about today or Solvency II in general, please feel free to contact us. Thank you, and we hope you’ll join us next time.

Voiceover (18:41):
Thank you for joining us on the Standard Formula. If you enjoyed this conversation, be sure to subscribe in your favorite podcast app so you don’t miss any future episodes. Additional information about Skadden can be found at skadden.com. The Standard Formula is a podcast by Skadden, Arps, Slate, Meagher & Flom, LLP and Affiliates. Skadden is recognized for its deep experience in representing insurance and reinsurance companies and their advisors on a wide variety of transactional and regulatory matters. This podcast is provided for educational and informational purposes only and is not intended and should not be construed as legal advice. This podcast is considered advertising under applicable state laws.