Meaning and How They work
What Is a Solvency Capital Requirement (SCR)?
A solvency capital requirement (SCR) is the total amount of funds that insurance and reinsurance companies in the European Union (EU) are required to hold. SCR is a formula-based figure calibrated to ensure that all quantifiable risks are considered, including non-life underwriting; life underwriting; health underwriting; and market, credit, operational, and counterparty risks. The solvency capital requirement covers existing business as well as new business expected over the course of 12 months. It must be recalculated at least once per year.
Key Takeaways
- Solvency capital requirements (SCR) are EU-mandated capital requirements for European insurance and reinsurance companies.
- The SCR, as well as the minimum capital requirement (MCR), are based on an accounting formula that must be re-computed each year.
- There are three pillars of reporting requirements for the SCR mandated by the Solvency II directive.
How Solvency Capital Requirements Work
Solvency capital requirements are part of the Solvency II Directive issued by the EU in 2009, which is one of more than a dozen existing EU directives. The directive aims to coordinate the laws and regulations of the 28 EU members as they relate to the insurance industry. If the supervisory authorities determine that the requirement does not adequately reflect the risk associated with a particular type of insurance, it can adjust the capital requirement upwards.
The SCR is set at a level that ensures that insurers and reinsurers can meet their obligations to policyholders and beneficiaries over the following 12 months with a 99.5% probability, which limits the possibility of falling into financial ruin to less than once in 200 cases. The formula takes a modular approach, meaning that individual exposure to each risk category is assessed and then aggregated.
Three Pillars of the Solvency II Directive
The EU Solvency II directive designates three pillars or tiers for capital requirements. Pillar I covers the quantitative requirements; that is, the amount of capital an insurer should hold. Pillar II establishes requirements for the governance, effective supervision, and risk management of insurers. Pillar III details disclosure and transparency requirements.
The demanding nature of Solvency II has attracted criticism. According to data services provider RIMESthe new legislation imposes complex and significant compliance burdens on many European financial organizations. For example, 75% of firms in 2011 reported that they were not in a position to comply with Pillar III reporting requirements.
The Minimum Capital Requirement
In addition to the SCR capital requirement, a minimum capital requirement (MCR) must also be calculated. This figure represents the threshold below which a national regulatory agency would intervene. The MCR is intended to achieve a level of 85% probability of adequacy over one year.
For regulatory purposes, the SCR and MCR figures should be regarded as “soft” and “hard” floors, respectively. That is, a tiered intervention process applies once the capital holding of the (re)insurance company falls below the SCR, with intervention becoming progressively more intense as the capital holdings approach the MCR. The Solvency II Directive provides regional regulators with several options to address breaches in the MCR, including the complete withdrawal of authorization from selling new policies and forced closure of the company.