Solvency II – Lessons for MENA Markets
The insurance sector is a core pillar of the global financial system covering a wide span of the economy from savings, investment and risk protection. The insurance industry differs from other industries by having the technical feature to buy and manage risk through variable maturities. Simply said, the core business model is built on pricing based on probability of risk being incurred; sharing part of the risk with (re)insurers, and then serving the customers through proper claim management practices when the risk is incurred.
Due to the important role in the economy, the insurance market is among the most heavily regulated sectors.
The insurance regulator or the supervisory authority intervenes in the insurance process for two fundamental roles: reduce the risk of insolvency of insurance companies, and protect policyholders’ rights.
Insurance companies' financial health and long term sustainability is assessed by their capital adequacy - as an ultimate residual buffer reflecting the company's asset liability management practice and ability to meet claims. They should therefore have sufficient capital to sustain their risk retention and maintain enough liquidity to match their liabilities towards policyholders. The approach for assessing risk capital is nevertheless rapidly changing given the macroeconomic, financial/market, and regulatory changes in both mature and developing markets.
Traditional capital requirements of insurance companies, known as Solvency I within the European Union’s single market, were originally "static" and calculated simply as a function of gross written premiums or claims incurred.
Solvency I did not develop to cope with the changes in the economy and rising of new risks. The 2007-2008 financial crises showed the weaknesses of the existing regulations due to its insensitivity to risks and to the absence of scientific risk management and economic transparency.
This was an opportunity for regulators to continue and speed their already started discussions on economic solvency principles.
Solvency II introduces market-consistent valuation of assets and liabilities, enhanced quality of capital, risk-based capital requirements, improved governance and risk management, a rough approach to group supervision, and strengthened market discipline through firm disclosures. Solvency II focuses on the risk profile of each insurance company in order to promote comparability, transparency and competitiveness.
The main purpose of solvency II is to assess the minimum amount of capital that insurance companies must hold to reduce the risk of insolvency and promote confidence in the financial stability of the insurance sector.
A capital falling below the minimum required level generates an early warning to supervisors to interfere.
The major benefits of Solvency II are enhancing risk and capital management, which in return can decrease operational costs, strengthen product offerings, and provide support for more optimal management decisions such as planning and strategy. The valuation of economic capital plays an important role in assessing credit ratings; therefore, using Solvency II capital model increases faith in a company’s creditworthiness and helps reduce the cost of raising capital.