Are you ready for Solvency II? U.S. insurers doing business in the European Union must begin to prepare for a revolutionary new solvency regime.

Solvency II, the comprehensive revision of insurance solvency regulations in the European Union that now is under way, will have far-reaching implications for insurers and reinsurers doing business in member countries. Insurers in the United States that have subsidiaries in Europe will be affected, and regulators even are talking about requiring insurance groups with head offices outside the European Union to set up a holding company in the European Union to facilitate regulatory supervision of their activities there.

Although issuance of the draft of the Solvency II directive has been postponed until mid-2007, the target date for local implementation in member states is still 2010. This means life and nonlife insurers and reinsurers have just four years to get ready.

The current European solvency regime, Solvency I, is a simplistic system that applies a small number of factors to accounting positions (premiums or reserves for nonlife and reserves and amount at risk for life reserves) to determine an insurer's capital requirements. Similar to the U.S. regulatory framework, Solvency I attempts to ensure policyholder protection through prudential reserving and a conservative investment strategy, without considering how the actual investment portfolio affects overall risk.

Solvency II seeks to correct this by taking a prospective and risk-oriented approach, with a three-pillar structure inspired by Basel II. Pillar I encompasses quantitative requirements; Pillar 2, supervisory activities and internal controls; and Pillar 3, supervisory reporting and public disclosure.

Solvency II will require both a quantitative and qualitative assessment of companies by the supervisors. The United Kingdom and Switzerland already have made changes to their solvency regulations in anticipation of Solvency II. U.S. companies with operations there already are dealing with the U.K's Individual Capital Assessments and the Swiss Solvency Test. Harmonization of the solvency systems in member states is a key European Commission objective.

Although the specific requirements of Solvency II have not been spelled out, insurers cannot wait for the final text to put in place a strong risk-management structure that will serve as the foundation for any required capital assessment. In terms of risk classification, all players now agree on the five risk categories proposed by the International Association of Actuaries: underwriting, market, credit, liquidity, and operational.

All players also agree on the need for a consistent approach to valuing assets and liabilities. In general, risk measures will be based on the volatility of asset and liability values, but there is no consensus on how to determine the market value of liabilities. While the European Commission prefers not to wait for a final text from the International Accounting Standards Board on this thorny issue, it has agreed that the solvency rules will be adjusted when the IASB finalizes Phase II of its insurance contracts project.

For many, specific quantitative assessment of the capital requirement is a major change. Even companies with existing economic capital models may find that Solvency II uses different risk definitions, creating a potentially challenging reconciliation effort.

Under Solvency II, the capital requirement for an insurer will be calculated on two levels:

* Minimum Capital Requirement: The level of capital below which "ultimate supervisory actions" (for example, license withdrawal) would be triggered.

* Solvency Capital Requirement: The level of capital that enables an institution to absorb large unforeseen losses.

But before calculating the capital requirement, insurers will be required to add a prudent margin to the "best estimate" of the liabilities in order to obtain a certain confidence level as to the adequacy of the liability provision. Then, the MCR would be calibrated as 100% of the current capital requirement over a three-year transition period.

The SCR may not be lower than the MCR and must take into account the quantifiable risks to which an insurer with a diversified portfolio of risks is exposed. The SCR would be based on the amount of an economic capital corresponding to an insolvency probability of 0.5% and a one-year time horizon. All these assumptions are working hypotheses that will be tested by quantitative impact studies now under way.

The debate about these and other issues will take place through mid-2007, after which the focus will be on implementation guidance. Given that time frame, all players affected by the new directive must begin to closely monitor the Solvency II project.

Robert W. Stein, a Best's Review columnist, is chairman of Global Financial Services for Ernst & Young. He may be reached at [e-mail] Jean-Charles Gueganou of E&Y's Paris office contributed to this column.