Solvency Capital Requirement

The Solvency Capital Requirement (SCR) is the main capital requirement for insurers and reinsurers under Solvency II, the prudential regime of the European Union. It is the amount of capital a firm needs in order to absorb significant unexpected losses and still be able to meet its obligations to policyholders. The requirement is risk-based: it rises and falls with the risks an insurer actually runs in its underwriting, its investments and its operations.

The SCR is the higher of two capital thresholds in the regime. Below it sits the Minimum Capital Requirement, a lower level beneath which a firm may lose its authorisation. Solvency II has applied since 1 January 2016. A closely related regime, now being adapted separately, applies in the United Kingdom under the Prudential Regulation Authority.

The SCR is defined as the capital needed to withstand losses over a one-year period at a confidence level of 99.5 per cent. In statistical terms it is the value at risk of the insurer's own funds at that level, often described as surviving a 1-in-200-year event. It must cover existing business and the new business expected to be written over the following twelve months, and it measures unexpected losses only, since expected claims are already provided for in technical provisions.

Firms may use one of two methods, or a mix of them:

• Standard formula. A calculation prescribed in EU rules. Capital charges are computed for each risk module by applying defined stresses or factors, and then combined using correlation tables that give credit for diversification.
• Internal model. A model built by the insurer to reflect its own risk profile, covering all risks (full) or some of them (partial). It requires prior approval from the supervisor, which checks statistical quality, calibration, validation, documentation and whether the model is really used in running the business.

Under the standard formula, the risk modules are market risk, counterparty default risk, life underwriting risk, non-life underwriting risk, health underwriting risk and intangible asset risk. These are aggregated into a basic requirement. A charge for operational risk is then added, and adjustments are made for the loss-absorbing effect of technical provisions, such as the ability to reduce future discretionary bonuses, and of deferred taxes.

Each module is built from sub-modules. Market risk, for example, combines interest rate, equity, property, spread, currency and concentration risk, and non-life underwriting risk combines premium and reserve risk, lapse risk and catastrophe risk.

The SCR must be covered by eligible own funds, broadly the excess of assets over liabilities plus qualifying subordinated debt, with assets and liabilities measured at market-consistent values. Own funds are classified into three tiers by quality. At least half of the SCR must be met with Tier 1 items, the most loss-absorbing, and Tier 3 items may make up no more than 15 per cent.

The ratio of eligible own funds to the SCR is the solvency ratio, the headline measure of an insurer's financial strength. A ratio of 100 per cent means the requirement is exactly met; most firms set an internal target well above that. Risk transfer lowers the requirement: an effective reinsurance cession or a catastrophe bond reduces underwriting charges, although reinsurance adds a charge for counterparty default. Close matching of assets to liabilities through insurance asset liability management reduces the market risk charge.

Insurers calculate the SCR in full at least once a year, monitor it continuously and recalculate it if their risk profile changes significantly. Results are reported to the supervisor and published annually in a solvency and financial condition report.

Falling below the SCR does not close a firm, but it triggers supervisory intervention. The insurer must inform its supervisor immediately, submit a realistic recovery plan within two months, and restore compliance within six months, a period the supervisor may extend. Supervisors can also impose a capital add-on where a firm's risk profile departs significantly from the assumptions behind its calculation or where its governance is seriously deficient. A breach of the Minimum Capital Requirement leads to much faster and more severe action.

The SCR belongs to the quantitative first pillar of the regime, together with rules on valuing technical provisions, which depend on claims reserving and discounting. The second pillar requires each firm to carry out an Own Risk and Solvency Assessment, in which it forms its own view of capital needs over its planning horizon and compares that view with the SCR. The third pillar covers disclosure.

The approach parallels bank regulation under Basel III, with differences: banks express requirements as ratios of capital to risk-weighted assets, while the SCR is an absolute amount derived from stressing the whole balance sheet.

Critics argue that the standard formula is complex yet still crude for unusual business models, that market-consistent valuation makes solvency ratios volatile, and that capital charges discourage insurers from holding long-term assets such as equities and infrastructure. The EU adopted amendments to the Solvency II Directive following a review begun in 2020, and the United Kingdom has reformed its version under the name Solvency UK, in both cases adjusting the calibration while keeping the SCR as the central measure.

• European Insurance and Occupational Pensions Authority
• Directive 2009/138/EC (Solvency II) on EUR-Lex