Understanding a breach of the SCR

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Carlos MontalvoSuggesting that the regulator will take a ‘relaxed’ attitude towards a breach in a firm’s SCR is unjustified, according to Carlos Montalvo, Executive Director of EIOPA. Instead he urges market participants to learn how to interpret this important regulatory tool correctly.

The idea of introducing a two tier capital requirement for Solvency II is designed to provide supervisors with a so called “supervisory ladder of intervention”. This ensures the supervisory response is tailored to the specific situation of the firm and represents a major cultural shift from the current regime.

Supervisors will treat the breach of the higher capital threshold, the SCR (Solvency Capital Requirement), as an indication that the financial soundness of the undertaking is deteriorating and take appropriate action. This approach is a cornerstone of a risk based framework that focuses on pre-emption and should not be viewed as a ‘relaxed’ attitude on the part of the supervisors towards firms that breach their SCR.

Since the Solvency II project started more than a decade ago, it has always been the intention to create two capital requirements in order to allow for a supervisory ladder of intervention. The recent market developments have no impact on this decision. There is, of course, a concern that some market participants, especially analysts and ratings agencies, might misinterpret this mechanism as a financial crisis in the company. Indeed, we have seen signs of this in the misguided criticism EIOPA received for using the lower of the two thresholds, the MCR (Minimum Capital Requirement), in its stress testing.

If analysts and other market participants focus only on the capital requirements, this would be a false approach. They should consider the amount of the breach of the SCR as well as understand the factors that caused it. And they will also be able to consult public disclosure (balance sheets, elements of governance, etc.) for more clarifications.

It should also be noted that capital requirement is not the only thing that can endanger the company. Other early warning signs of trouble could relate to governance requirements; frequent changes of management or bad management in principle can also lead to the collapse of a company.

As regulators, and as an industry as a whole, we have a job on our hands: to make sure the breach in the SCR is interpreted as it is intended. Market participants and supervisory authorities must have the same understanding of the solvency ratio in Solvency II and it is very important to differentiate the MCR from the SCR. This is crucial.

The breach of the MCR triggers a very strict recovery plan and if that plan is not complied with, the company will be closed down. The SCR is a regulatory tool for monitoring the financial soundness of a firm. The supervisor will have a possibility to interpret the breach of the SCR because sometimes the difficult situation of the company is not due to a fundamental unsoundness, but can be caused by exceptional market volatility.

It might be the case that solvency ratios are not well understood by markets. But at the same time markets will know that in case of a breach in the SCR, the supervisor will enter into discussion with the company and a recovery plan will be implemented. The supervisor will also have to state that the breach in the SCR does not mean that the company is insolvent.

EIOPA stands ready to help educating supervisors, investors, analysts and the media on how to interpret a breach in the SCR. As indeed this is a significant cultural change, and like all changes of this magnitude, it requires care and attention to produce the best results.

The author is Executive Director of the European Insurance and Occupational Pensions Authority (EIOPA). The views expressed are the author’s own.

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